Kamakura Releases 10 Year Monthly Forecast of U.S. Treasury Yields and Swap Spreads for October, 2011

New York - 17 October 2011

Honolulu-based Kamakura Corporation on Monday released its forecast for U.S. Treasury yields and interest rate swap spreads monthly for the next 10 years. The forecasted 1 month US Treasury bill rates increased up to 29 basis points throughout the intermediate term but decreased as much as 22 basis points from 2019 to 2021 compared to the previous forecast.

The Kamakura forecast for October shows 1 month Treasury bill rates rising steadily to 3.585% in September 2021, down 22.5 basis points from the peak forecasted last month. The 10 year U.S. Treasury yield is projected to rise steadily to 3.896% on September 30, 2021, 32.2 basis points lower than forecasted last month. The negative 29 basis point spread between 30 year U.S. dollar interest rate swaps and U.S. Treasury yields reflects the blurring of credit quality between these two yield curves. The U.S. government has not been seen as risk free by the market for some time as evidenced by the negative spread, and 4 of the 19 panel banks that determine U.S. dollar libor are receiving significant government assistance and are, in effect, sovereign credits. The negative 30 year spread results in an implied negative spread between 1 month libor and 1 month U.S. Treasury yields (investment basis) beginning in 2016 to 2021.

Kamakura Chief Administrative Officer Martin Zorn said Monday, “The forward curve not only reflects the continued uncertainty in Europe and the fear of a global economic slowdown but also incorporates the Twist. This can be clearly seen in the flattening of the long end of the curve.”

The negative spread between interest rate swaps and US Treasuries implies a period of negative spreads between the Libor-swap curve and Treasuries and dramatic spread gyrations around mid-2012, as shown in this graph. This distortion comes about because the Libor Swap curve has two components with dramatically different credit risk. The short term rates are from the Libor market where in theory market participants can lose 100% of credit extended to banks. In the swap market, however, losses can be no more than the difference in the net present value of the swap between the origination date and the default date. Market participants generally ignore this credit differential and that is what causes the gyrations.

The Kamakura interest rate forecasts are based on the forward interest rates embedded in the current U.S. Treasury yield curve and in the interest rate swap curve. These forward rates are extracted using the maximum smoothness forward rate approach first published by Kamakura’s Donald R. van Deventer and Kenneth Adams in 1994 and modified in Financial Risk Analytics (1996) by Kamakura’s Imai and van Deventer. The maximum smoothness approach is applied directly to forward rates in the case of U.S. Treasury yields and it is applied to forward credit spreads, relative to the U.S. Treasury curve, in the case of the swap curve. For a 50 year history of maximum smoothness forward rates, see Dickler, Jarrow and van Deventer (2011) “Inside the Kamakura Book of Yields: A Pictorial History of 50 Years of Daily U.S. Treasury Forward Rates”.

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