Since May, the spread between one- and 10-year advance yields has narrowed from 213 basis points, to 196 basis points. The spread between three-month and two-year advance rates narrowed slightly, from 106 basis points to 105 basis points.

The relative “roll-down” benefit in the two-year sector decreased slightly from 109 basis points, to 101 basis points. This implies that benefit is continuing to accrue in terms of investing in a two-year, versus a one-year security.

Consider the following investment alternatives covering a one-year time horizon:

• Purchase a one-year, fixed-income security (assumed to be pegged to Seattle Bank Advance Yield Curve), in this example, 3.40%.
• Purchase a two-year, fixed-income security and sell after one year, in this example, 3.90%.

In deciding whether to purchase the one-year security, as opposed to purchasing the two-year security and selling it at the end of one year, an investor would like to know the answer to a key question: In the event of rising interest rates, even though a modest principal loss would be sustained, would the extra yield earned, relative to one-year portions of the yield curve, more than offset the loss?

Under current market conditions, there is, by historical standards, an increasing degree of protection from rising rates over a one-year period for an investor that opts to purchase a two-year security and sell it at the end of the first year. At current levels, the current implied forward yield curve indicates that an investor would better off by investing in a two-year security. Conversely, a borrower would be relatively worse off borrowing in the two-year sector and better off borrowing in the one-year sector (notwithstanding a borrower’s unique balance sheet, liquidity and other related considerations.)

The chart of current-versus-future implied swap yield curves suggests that short-term rates are expected to increase on the order of 100 basis points over the next 12 months. Longer-term rates are still expected to increase on the order of 25 basis points one year from now. These variables would suggest a flattening of the yield curve in the future due to higher forecast short-term rates.

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