Weekly Forecast, March 24: Calculating The Default Risk Of Interest Rate Mismatches

In this week’s interest rate simulation, we’re looking at the likelihood of default when banks, institutional investors, or individual investors have a significant interest rate mismatch between their assets and liabilities. This topic has long needed attention, and we’re glad to see it finally being tackled.

The Probability of Default

Based on Friday’s closing U.S. Treasury yield curve, the probability of an inverted yield curve ending by September 22, 2023, has increased from 24.9% to 37.7% this week. This means that the likelihood of a recession shortly is higher than we previously thought.

To further explain this, we need to look at the risk premium. Forward rates contain a risk premium above and beyond the market’s expectations for the 1-month forward rate. This risk premium is the reward for long-term investment and is currently quite large. However, it’s also narrowing over the full maturity range to 30 years.

Historical movements in Treasuries suggest a steady decline in expected 3-month rates for five years after an initial peak. It’s essential to monitor these trends and adjust investment strategies accordingly.

Interest Rate Behavior

When looking at interest rate behavior, we need to focus on three elements: the future probability of a recession-predicting inverted yield curve, the possibility of negative rates, and the probability distribution of U.S. Treasury yields over the next decade.

Using a maximum smoothness forward rate approach, Friday’s implied forward rate curve shows a quick rise in 1-month rates to an initial peak of 5.19%, compared to 4.89% last week. However, after this initial rise, there is a decline before rates peak again at 3.46%, compared to 3.54% last week. Rates then peak again at 4.85%, compared to 4.91% last week, before declining to a lower plateau at the end of the 30-year horizon.

Simulating 500,000 future paths for the U.S. Treasury yield curve out to thirty years, we measure the probability that the 10-year par coupon Treasury yield is lower than the 2-year par coupon Treasury for every scenario in the first 80 quarterly periods in the simulation. The probability of an inverted gain remains high, peaking at 62.3%, down substantially from 75.1% one week ago.

Related Facts

• The negative 2-year/10-year Treasury spread has now persisted for 180 trading days, currently at a negative 38 basis points compared to negative 42 last week.
• The current streak of inverted yield curves is the fourth longest in the U.S. Treasury market since the 2-year Treasury yield was first reported on June 1, 1976.

Key Takeaway

Investors need to know the risk associated with interest rate mismatches and the probability of a recession shortly. Therefore, adjusting investment strategies accordingly and monitoring interest rate behavior is crucial.

Conclusion

The default risk of interest rate mismatches is a topic that’s long been ignored. However, it’s time for investors to take this issue seriously and adapt their strategies to prepare for the probability of a recession shortly. With the information provided in this week’s interest rate simulation, investors can stay informed and adjust their investments.