Honolulu-based Kamakura Corporation on Tuesday released its forecast for U.S. Treasury yields and interest rate swap spreads monthly for the next 10 years. The forecast this week is up substantially from last month in the intermediate maturities. There is a significant steepening of the curve through 2018 compared to last month. U.S. dollar Libor-swap spreads to the U.S. Treasury curve also continue to imply short term Libor rates below the matched maturity U.S. Treasury yield for years into the future starting in 2018.
The Kamakura forecast for April shows 1 month Treasury bill rates rising steadily to 5.52% in March 2021, down 16 basis points from the peak forecasted last month. The 10 year U.S. Treasury yield is projected to rise steadily to 5.67% on March 31, 2021, 10 basis points higher than forecasted last month. The negative 22 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 is no longer seen as risk free, and 4 of the 20 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 2015-2016 and again in 2018-2021.
Kamakura chief administrative officer Martin Zorn said Monday, “The twists at various points in the yield curve over the last several weeks should be a call to action for market participants to prepare for interest rate volatility associated with an increased level of uncertainly. Given the events that we witnessed in Washington regarding the budget and debt limit caps this should not be a surprise.”
The negative spread between interest rate swaps and US Treasuries implies an extended period of negative spreads between the Libor-swap curve and Treasuries and dramatic spread gyrations around mid 2011. 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.
