The_Yield_Curve_Officially_Inverts_In_3Q2019
00:00:00.000 | Hello, everybody.
00:00:01.000 | It's Sam from Financial Samurai, and it is August 14, 2019.
00:00:07.160 | And just wanted to talk about the inverted yield curve, which we are now experiencing.
00:00:12.160 | The 10-year bond yield is now lower than the 2-year bond yield, and that means an official
00:00:18.840 | inversion.
00:00:20.560 | And the 10-year bond yield has been below the 3-month bond yield and the 1-month bond
00:00:24.640 | yield for a while now, which could also mean inversion, but the classic definition of inversion
00:00:30.800 | is the 10-year below the 2-year.
00:00:34.200 | But at any rate, the yield curve has been flat inverted for a year, year and a half
00:00:40.520 | now.
00:00:41.520 | And it's also interesting to note that if you look at history, whenever the yield curve,
00:00:47.040 | the official definition of the yield curve inverts, 10-year and 2-year, a recession comes
00:00:52.520 | in 6 to 18 months.
00:00:54.920 | So if you've been wondering what's going on with the housing market, where volume is low
00:01:00.120 | and prices aren't rocketing higher, it might be because a lot of consumers are thinking
00:01:05.960 | this is it.
00:01:07.440 | 2018 was a scare when median property prices fell up to like 10 plus percent in many markets
00:01:14.720 | from the first quarter 2018 to the end of 2018.
00:01:20.020 | And people are just wondering, hmm, maybe we shouldn't be buying right now.
00:01:23.820 | And maybe there is pent up demand actually as well, because rates, mortgage rates are
00:01:28.640 | down at least 1%, if not more like 1.25% from 2018.
00:01:34.600 | And that should increase buying power and increase demand for property.
00:01:39.620 | But we're not seeing that just yet because I think people are just taking a wait and
00:01:44.300 | see approach.
00:01:45.460 | Because again, fourth quarter 2018 was pretty, pretty bad.
00:01:48.420 | The market sold off like 15 plus percent.
00:01:51.940 | So I just wanted to talk about the inversion again, because we talked about this before
00:01:56.840 | and it's good to get an idea of what's going on.
00:02:01.720 | So the way to understand the yield curve is to look at it from different perspectives.
00:02:06.100 | So from the lender's perspective, due to inflation, the value of a dollar tomorrow is worth less
00:02:11.300 | than the value of a dollar today.
00:02:13.100 | So therefore, in order to profitably lend money, you must charge an interest rate.
00:02:18.300 | The longer the lending term, the higher the interest you should charge, hence the upward
00:02:23.020 | slope of the yield curve.
00:02:25.140 | If the borrower has poor credit score, runs an unstable business, has large job gaps in
00:02:30.900 | his or her resume, doesn't read Financial Samurai or listen to Financial Samurai, you're
00:02:35.900 | going to have to charge a higher rate.
00:02:37.820 | And it's pretty logical.
00:02:39.860 | So if you are a bank, your main source of funding is from savings deposits.
00:02:45.000 | For the privilege of holding such deposits, you pay customers an interest rate and hope
00:02:49.620 | to lend out their deposits at a higher interest rate for a positive net interest margin.
00:02:55.420 | This is the classic way banks do business.
00:02:58.140 | It's been going on for a century plus, and that's how the yield curve is upward sloping.
00:03:04.140 | So from a borrower's perspective, it's a little bit opposite here.
00:03:08.540 | A rational borrower is incentivized to borrow as much money as possible for as long of a
00:03:14.020 | period as possible at the lowest interest rate possible to hopefully get rich.
00:03:19.900 | The more you borrow, the more you will likely invest.
00:03:23.720 | And when the borrowing rate is equal to or below the inflation rate, a borrower is essentially
00:03:28.940 | getting a free loan.
00:03:31.500 | So the classic borrower example is the homebuyer.
00:03:33.700 | After putting about 20% down on average, the buyer borrows the remaining 80%.
00:03:38.820 | The lower the interest rate, the more inclined the borrower is to take on more debt to buy
00:03:42.360 | a bigger, fancier house.
00:03:44.660 | So for people looking to buy property right now, it's a good time to look.
00:03:49.460 | Although down cycles in the property market can last 3-5 years on average, looking now
00:03:54.740 | when inventory is higher and rates are lower is a much better time than looking last year.
00:04:00.980 | So when homebuyers want to stretch, they take out an adjustable rate mortgage with lower
00:04:05.740 | interest rates versus 30 year fixed and so forth.
00:04:08.720 | In addition to homebuyers, there are companies large and small that borrow money to grow
00:04:12.260 | their respective businesses.
00:04:14.180 | If interest rates are lower at every duration, businesses will tend to borrow more, invest
00:04:18.620 | more, hire more, and consequently boost GDP growth.
00:04:22.380 | So the equation for GDP equals consumer spending plus investment plus government spending plus
00:04:30.560 | net exports.
00:04:32.460 | That's GDP growth.
00:04:34.540 | And then from the investor's perspective, given the motivations of the borrower and
00:04:38.780 | the lender, the investor sees the yield curve as an economic indicator.
00:04:43.220 | The steeper the yield curve up to a point, the healthier the economy.
00:04:47.320 | The flatter the yield curve, the more cause for concern given the borrower's doubt about
00:04:52.900 | the near future.
00:04:54.740 | So right now, you are seeing the 10 year bond yield at about 1.6%, whereas the 2 year bond
00:05:02.340 | yield is about 1.65%, and the 1 month bond yield is about 2.15%.
00:05:11.960 | So it's pretty inverted right now.
00:05:15.100 | So with such an inverted yield curve, if you're the bank, you're disinclined to lend money
00:05:19.700 | over a long duration because the return is too low relative to the short end.
00:05:24.260 | You are paying higher deposit rates, so you're getting squeezed there because it costs more,
00:05:31.580 | and then you're getting less in profits because you're lending for a long term at a lower
00:05:36.380 | rate.
00:05:37.380 | So what happens?
00:05:38.380 | You just stop lending as much, and you also tighten lending standards.
00:05:42.020 | And from the borrower's perspective, you're just hoarding cash because the future doesn't
00:05:47.620 | look very bright.
00:05:48.620 | It's very uncertain.
00:05:49.820 | But the short term, you're getting 2.1% to 2.3% interest rate on your cash.
00:05:55.980 | It's risk-free up to $250,000 for the FDIC.
00:05:59.460 | And so the logical conclusion is that you hoard cash, and you wait.
00:06:03.860 | You don't invest in the future.
00:06:07.140 | And what happens?
00:06:08.140 | What happens?
00:06:09.140 | Well, the velocity of money that turns and turns around in the economy slows down.
00:06:14.500 | And when that slows down, economic growth slows down.
00:06:19.040 | And that is why we've seen historically whenever the yield curve inverts, a recession is 6
00:06:25.620 | to 18 months away.
00:06:27.700 | And if you look at history, just look at history, look at the post, look at some charts, 1989,
00:06:33.780 | '88, the yield curve inverted.
00:06:37.620 | A recession came in 1991.
00:06:40.740 | If you look at 1999, the yield curve inverted.
00:06:44.260 | A recession came in 2000.
00:06:46.620 | If you look at 2007, the yield curve inverted.
00:06:50.780 | There was a recession, big one, obviously, in 2008, 2009.
00:06:54.980 | So I really don't think this time is different.
00:06:57.680 | Investing is rational long term.
00:07:00.180 | Investors take action to enrich themselves while doing their best to avoid actions that
00:07:04.180 | will make them poor.
00:07:06.180 | If I want six-pack abs, I'm going to drink water every day and only eat celery and do
00:07:11.100 | 1,000 sit-ups, and then I'm rationally going to get six-pack abs and kind of not feel so
00:07:16.980 | good because I'm starving.
00:07:19.260 | And everything else long term is very rational.
00:07:22.740 | Short term, kind of irrational, right?
00:07:24.340 | Like when the Fed raised rates in December 2018 when the yield curve was already flat,
00:07:30.660 | it's just dumb.
00:07:33.940 | And so they reversed course, right, seven and a half months later.
00:07:36.660 | But they're just dumb.
00:07:37.660 | There's like short-term irrational noise, everything.
00:07:40.360 | But long term, you've got to think rationally.
00:07:42.880 | And so on your road to financial independence, your goal is to not lose massive money because
00:07:49.740 | not only does losing massive money hurt.
00:07:52.920 | It takes away time and time becomes more and more valuable.
00:07:56.780 | Again, if you lose 50% of your money, you've got to get 100% return just to get to even.
00:08:03.060 | And worse is that it probably will take you several years of work and saving and investing
00:08:07.940 | to get back to even.
00:08:09.520 | And you don't want that.
00:08:10.740 | You just don't want that.
00:08:12.480 | So everybody right now needs to take advantage of short-term rates.
00:08:17.520 | You're getting 2% to 2.5%.
00:08:21.420 | Some banks are subsidizing the consumer by paying higher rates to get more deposits.
00:08:27.220 | But most banks are not.
00:08:28.780 | They're going to cut rates now because the Fed has started cutting rates.
00:08:31.900 | So you get it.
00:08:32.900 | Hoard cash.
00:08:34.160 | You have got to refinance your mortgage.
00:08:36.880 | You want to refinance into the sweet spot of the yield curve.
00:08:39.860 | So we're talking seven-year and 10-year arms.
00:08:43.380 | That is the sweet spot where you get the most bang for your buck.
00:08:46.940 | That's good duration.
00:08:48.140 | The average homeowner only owns his or her home for about eight to nine years.
00:08:52.740 | So if you're refinancing seven- to 10-year fix, that is pretty sweet.
00:08:57.980 | And you probably also want to look at real estate.
00:09:01.020 | Real estate right now is a little bit soft because inventory is piling up in a lot of
00:09:06.420 | these big cities.
00:09:07.420 | It's a boom-bust cycle.
00:09:09.620 | But you don't have to pay the market rate right now.
00:09:12.620 | You should look.
00:09:13.620 | You should see what's out there.
00:09:15.380 | And you should lowball, especially stale fish listings where the broker just simply missed
00:09:20.620 | price and it's been on the market for months, maybe years.
00:09:25.260 | That to me is pretty interesting.
00:09:27.500 | And especially since you're going to save about one to one and a quarter percent on
00:09:30.620 | your mortgage if you've got to take a mortgage, that's pretty rational to me.
00:09:34.820 | So I hope everybody is paying attention.
00:09:37.140 | If you've got a day job, be nice to your boss and colleagues because during recessions,
00:09:42.820 | people who are not nice are also the first ones to go.
00:09:45.820 | Thanks, everyone.
00:09:47.180 | Stay safe out there.
00:09:48.660 | And if you like this podcast, please leave a positive review.