Friday Forecast: 10 Year Forecast of U.S. Treasury Yields And U.S. Dollar Interest Rate Swap Spread

This week's projections for the 1 month Treasury bill rate (investment basis) show a strong rise in intermediate maturity rates compared to October 21, with the biggest changes being increases of more than 25 basis points in 2017 and increases across the board from late 2012 through 2020.  The implied forecast this week shows a steady rise in the 1 month bill rate to a peak of 4.724% in September 2020, up 3 basis points from last week.  The 10 year U.S. Treasury yield is projected to rise steadily to reach 5.266% on September 30, 2020, up 11 basis points from the corrected figure from last week.

U.S. dollar swap spreads this week were a negative 37 basis points at 30 years. Today's forecast continues to imply a rise and fall of spreads between the libor-swap curve and U.S. Treasuries, with a local peak in the 1 month spread of 62.1 basis points in February 2011, down 1 basis point from last week. Thereafter, swap spreads drop to a negative spread of 53.2 basis points in September 2011. Spreads turn positive thereafter until December 2015, and they then remain negative through 2020. The libor-swap curve itself shows a peak in 1 month libor at 89 basis points in March 2011 and a fall to negative 26.3 basis points in September, 2011.

These negative spreads between U.S. dollar interest rate swaps and U.S. Treasury yields reflect the blurring of credit quality between these two yield curves.  The U.S. government is no longer seen as risk free. Eurodollar rates used here are collected by the U.S. Federal Reserve and are different from the "official" libor rates collected by Thomson Reuters on behalf of the British Bankers Association. As reported in other blogs on this website, there is increasing evidence that the BBA Libor figures have been consistently set at below actual funding costs during the credit crisis that started in 2007. The U.S. dollar libor panel used by the British Bankers Association consists of 16 banks, and 4 of the 16 panel banks that determine U.S. dollar libor are receiving significant government assistance and are, in effect, sovereign credits. The current U.S. dollar libor panel members, last adjusted in May 2009, are the following banks:

• Bank of America
• Bank of Tokyo-Mitsubishi UFJ
• Barclays Bank PLC
• Citibank NA
• Credit Suisse
• Deutsche Bank AG
• HSBC
• JP Morgan Chase
• Lloyds Banking Group
• Norinchukin Bank
• Rabobank
• Royal Bank of Canada
• Royal Bank of Scotland Group
• Societe Generale
• UBS AG
• WestLB AG

For more on the panel members, see www.bbalibor.com. Please note that there are periods of dramatic differences between the libor rates reported by the British Bankers Association, using the panel above, and the Eurodollar rates reflected in the H15 statistical release.  Those differences are summarized in this recent blog entry on www.kamakuraco.com:
van Deventer, Donald R. "Kamakura Blog: Default Probabilities and Libor," Kamakura blog, www.kamakuraco.com, June 7, 2010. Redistributed on www.riskcenter.com on June 8, 2010.

Background Information on Input Data and Smoothing

The Federal Reserve H15 statistical release is available here:
http://www.federalreserve.gov/Releases/H15/Update/

The maximum smoothness forward rate approach to yield curve smoothing was described in this blog entry:
van Deventer, Donald R. "Basic Building Blocks of Yield Curve Smoothing, Part 10: Maximum Smoothness Forward Rates and Related Yields versus Nelson-Siegel," Kamakura blog, www.kamakuraco.com, January 5, 2010.  Redistributed on www.riskcenter.com on January 7, 2010.

The use of the maximum smoothness forward rate approach for bond data is discussed in this blog entry:
van Deventer, Donald R. "Basic Building Blocks of Yield Curve Smoothing, Part 12: Smoothing with Bond Prices as Inputs," Kamakura blog, www.kamakuraco.com, January 20, 2010. Redistributed on www.riskcenter.com on January 21, 2010.

The reasons for smoothing forward credit spreads instead of the absolute level of the libor-swap curve were discussed in this blog entry:
van Deventer, Donald R. "Basic Building Blocks of Yield Curve Smoothing, Part 13: Smoothing Credit Spreads," Kamakura blog, www.kamakuraco.com, April 7, 2010. Redistributed on www.riskcenter.com, April 14, 2010.

The Kamakura approach to interest rate forecasting was introduced in this blog entry:
van Deventer, Donald R. "The Kamakura Corporation Monthly Forecast of U.S. Treasury Yields," Kamakura blog, www.kamakuraco.com, March 31, 2010. Redistributed on www.riskcenter.com on April 1, 2010.

For more information about the yield curve smoothing and simulation capabilities in Kamakura Risk Manager, please contact us at info@kamakuraco.com.  Kamakura interest rate forecasts are available in pre-formatted Kamakura Risk Manager data base format.

Donald R. van Deventer
Kamakura Corporation
Honolulu, October 29, 2010