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 show a continued flattening of the curve with decreases of 25 to 36 basis points from 2016 to 2022 compared to the previous month.
The Kamakura forecast for May shows 1 month Treasury bill rates rising steadily to 3.708% in April 2022, down 24.2 basis points from the peak forecasted last month. The 10 year U.S. Treasury yield is projected to rise steadily to 3.67% on April 30, 2022, 26.5 basis points lower than forecasted last month. The negative 27 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 18 panel banks that determine U.S. dollar libor have received significant government assistance and are, in effect, sovereign credits. For more on the panel members, see www.bbalibor.com. 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 2020 to 2022.
Kamakura Chief Administrative Officer Martin Zorn said Monday, “The flattening of the forward curve in May is a reflection of the data released in April. The April payroll numbers in the US and the corresponding reaction by the Fed demonstrated that monetary policy was not going to be adjusted unless there is sustainability to the trend.”
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.
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.
Kamakura’s rate forecast is available in electronic form, both in Kamakura Risk Manager table format and other forms, by subscription.