Understanding-The-Yield-Curve
00:00:00.000 | Hello everybody, it's Sam from Financial Samurai and I thought it would be a good idea to talk
00:00:03.920 | about the yield curve, which I think is one of the best economic predictors. So you may be hearing
00:00:10.240 | more about the yield curve lately because the yield curve is flattening out. And I just wanted
00:00:15.840 | to use this podcast to explain why the yield curve is important and why an inverted yield curve is a
00:00:24.080 | clear sign of an upcoming recession. Now some people say, well, this time it's different.
00:00:29.760 | I want to say that this time is not different because investors are rational. All of us are
00:00:36.480 | rational because we want to do things to make us more money and do less of the things that could
00:00:41.680 | lose us money. The yield curve is a curve on a graph in which the yield of fixed interest securities
00:00:47.680 | is plotted against the length of time they have to run to maturity. So for example, treasury notes,
00:00:54.080 | you know, one month note, three month note, six month note, 12 month note, those are the short end
00:01:00.080 | and then the longer end, three year, five year, 10 year, 30 year. So the yield curve is almost
00:01:06.480 | always upward sloping, which is a sign that the economy is functioning properly. And to best
00:01:12.240 | understand the yield curve, all you've got to do is put yourself in the shoes of the lender,
00:01:16.880 | the borrower and the investor. Each entity is rational and looking to do what's best for their
00:01:22.400 | bottom line. So let's start with the lender's perspective. Due to inflation, the value of a
00:01:27.360 | dollar tomorrow is worth less than the value of a dollar today. Hence, in order to profitably lend
00:01:33.280 | money, you must charge an interest rate. And the longer the lending term, the higher the interest
00:01:38.960 | you should charge, hence the upward slope of the yield curve. Now, if the borrower has a poor credit
00:01:44.320 | score, is not a Financial Samurai podcast listener, runs an unstable business, has like a three year
00:01:51.040 | gap year where he or she had no job, you're probably going to need to charge an even higher
00:01:56.160 | rate to account for credit risk. If you can get a borrower to pay back an interest rate higher than
00:02:01.920 | your competition, you're making a superior economic return. And this is exactly what banks do. They
00:02:08.960 | have complex models, actuaries, all these people trying to figure out risk, and hopefully they can
00:02:15.920 | lend enough money at a high enough volume with a high enough spread to make a profit. So your main
00:02:21.840 | source of funding as a bank is from savings deposits. And this is the shortest term. So
00:02:26.480 | that's why over the past several years, your money market account only pay like point 1% to point 5%.
00:02:32.880 | Banks were loving it because they didn't, they didn't have to pay you the money, they could
00:02:37.280 | just pay such a low interest rate. And then they could turn around and lend it for a higher
00:02:42.320 | interest rate. So that is what a bank does. They take in your deposits, pay you a small rate,
00:02:48.080 | and hopefully re-lend that money at a higher rate to earn a positive net interest margin gain. So
00:02:54.960 | the yield curve is upward sloping, banks have an easier time achieving such profitability. Now from
00:03:00.560 | a borrower's perspective, a rational borrower is incentivized to borrow as much money as possible
00:03:06.640 | for as long a period of time as possible at the lowest interest rate possible to get rich. Now,
00:03:12.960 | the more you borrow, the more you will likely invest. And when the borrowing rate is equal to
00:03:17.840 | or below the inflation rate, a borrower is essentially getting a free loan. So back in
00:03:24.160 | 20 around 14, I was able to lock in an adjustable rate mortgage of 2.375%. And that was great
00:03:33.120 | because the 10-year bond yield was at about 2.35% as well. It was probably more like around 2.1%.
00:03:40.080 | But now the 10-year bond yield is at 2.85%. So I've essentially locked in several more years
00:03:47.760 | of an interest rate that is below inflation. So I'm actually borrowing money for free while the
00:03:54.560 | asset price goes up. So that's pretty sweet, right? So the classic borrower example is the
00:03:59.280 | homebuyer. After putting 20% down, the buyer borrows the remaining 80%. The lower the interest
00:04:04.880 | rate, the more inclined the borrower is to take on more debt to buy a bigger and fancier house.
00:04:10.800 | And when homebuyers really needed to stretch, they took out short-term adjustable rate mortgages. So
00:04:16.160 | you had a one-year adjustable rate mortgage, three-year and five-year. Those are the most common
00:04:20.720 | compared to a 30-year fixed loan with higher rates. Now, I've been a proponent of taking out
00:04:27.600 | an adjustable rate mortgage since 2009. Because if you look at the history of interest rates,
00:04:33.600 | they've been going down since the late '80s. So in a declining interest rate environment,
00:04:38.720 | taking out an arm is an optimal move. But in a rising interest rate environment,
00:04:44.080 | you may get a little bit squeezed once the arm resets. But I still think we're in a lower-for-
00:04:50.160 | longer interest rate environment. It's just recently we've come off from the very lows of
00:04:54.080 | the lows, and we're kind of ticking up. But I don't think it's going to go that much higher.
00:04:58.800 | So in addition to homebuyers, there are companies, large and small, that borrow money to grow their
00:05:03.040 | respective businesses. If interest rates are lower at every duration, businesses will tend to borrow
00:05:09.200 | more, invest more, hire more, and consequently boost GDP growth. So the equation for GDP growth
00:05:16.880 | is y equals c plus i plus g plus nx. So c is consumer spending, i is investment, g is government
00:05:28.240 | spending, and nx is net exports. So the i is very important in GDP growth. And when interest rates
00:05:35.440 | are low, that spurs more investments. Now let's look at the investor's perspective.
00:05:42.800 | Given the motivations of the borrower and the lender, the investor sees the yield curve as an
00:05:48.160 | economic indicator. The steeper the yield curve, up to a point, the healthier the economy. I say
00:05:53.520 | up to a point because if it's super steep and super high, it's probably not a good economic
00:05:59.520 | environment because there's inflation, maybe hyperinflation, and higher interest rates will
00:06:04.960 | choke off growth. The flatter the yield curve, the more cause for concern given the borrower's doubt
00:06:11.840 | about the near future. So if there's a lack of demand for short-term bonds, pushing short-term
00:06:17.760 | yields higher, perhaps there is doubt about short-term economic growth. We know that the
00:06:23.840 | average recession lasts 18 months. So if that's the case, maybe you don't want to really invest
00:06:30.240 | in anything over the next two years. Similarly, if investor demand for long-term bonds keeps long-term
00:06:36.880 | yields low, this may mean investors don't believe there are inflationary pressures because the
00:06:42.320 | economy isn't viewed as trending stronger. If the long-term view of the economy is, you know, even
00:06:47.840 | tighter job market, even stronger corporate earnings, even more competition, and so forth,
00:06:55.280 | that's inflationary. And if that's inflationary, people aren't going to want to hold bonds.
00:07:00.320 | They want to hold assets that inflate with inflation or hopefully faster than inflation.
00:07:06.720 | Short-term yields are also artificially pushed up by the Federal Reserve since the Fed Fund
00:07:12.320 | rate is the overnight banking lending rate. And that's the shortest of the short, right?
00:07:17.200 | Overnight rate. An investor needs to make a calculated guess as to how often and how aggressively
00:07:23.280 | the Federal Reserve will raise their Fed Funds rate and how the bond market will react to such
00:07:28.560 | moves. The bond investor wins if inflation comes in below expectations. Inflation comes in below
00:07:36.560 | expectations when economic growth comes in below expectations. And the stock market investor wins
00:07:42.960 | if economic growth comes in above expectations, generating stronger corporate earnings growth,
00:07:48.240 | while interest rates remain at a level high enough to contain faster than expected inflation,
00:07:53.440 | while not choking off investment growth. So the Federal Reserve targets about a 2 to 2.3%
00:08:01.360 | annual CPI inflation. And whenever it's trending higher than that, they'll tend to raise rates
00:08:08.800 | further. And when it's trending below that, they'll tend to cut rates. So right now we're
00:08:13.280 | at about 2%. We're kind of at this natural rate of unemployment and inflation level.
00:08:19.520 | So I think that's pretty good. But we shall see about the future, because nobody knows except
00:08:23.760 | for them. And not even they know what the economic future will lie. They're making best case
00:08:28.720 | guesstimates themselves. So if you look at the yield curve over the past three years, it is
00:08:33.280 | definitely flattened because the long end has not risen as fast as the short end, right? Because the
00:08:39.600 | Fed has been raising rates, I think, since end of 2016. So the long end, like the 10-year bond
00:08:44.400 | yield, for example, did come from a low of about 1.6%, 1.8%, and now it's at about 2.8%. But the
00:08:52.880 | short end has risen even further, hence the flattening. So if the Fed raises the Fed funds
00:08:58.640 | rate by another half a percent or 50 basis points in the next 12 months, the yield curve will be
00:09:04.880 | completely flat, if not inverted by 2019, if long term rates stay the same. And I definitely
00:09:11.680 | recommend you go over and click to the post and check out these awesome graphs. And with a flat
00:09:16.160 | yield curve, you're disinclined to lend money over a long duration because the return is too low
00:09:21.520 | relative to the short end. As a result, you tighten up lending standards and lend to only the most
00:09:26.160 | creditworthy people. And that's kind of the irony. Over the past five, six, seven years since the
00:09:31.120 | financial crisis, only the highest creditworthy people got loans, and probably only the people
00:09:37.680 | who really didn't need a loan got loans, and the most desperate people were shut out. And as a
00:09:43.360 | lender, you'd rather lend money for as short a time as possible because the interest rate you receive
00:09:48.080 | is similar to the long end. That makes sense. And shorter lending time horizon is also less risky
00:09:55.280 | than longer time horizon, right? You don't, it's hard to predict 10 years from now what's going to
00:09:59.920 | happen. But it's much easier to predict what's going to happen in the next six to 12 months.
00:10:03.600 | So unfortunately, for borrowers, they think exactly the opposite. The borrowers are less
00:10:08.240 | inclined to borrow capital short term if the interest rate is very similar to long term
00:10:13.280 | interest rates. They'd rather borrow at the same rate for a longer time period, but they're often
00:10:17.680 | shut out due to more stringent lending standards. If the yield curve inverts, or in other words,
00:10:23.520 | when the short term interest rates are higher than long term interest rates, the rational borrower
00:10:28.880 | slows or stops his or her borrowing. Only the most desperate, desperate least creditworthy
00:10:35.360 | borrower takes out a short term loan at a higher interest rate. So just think about all those
00:10:39.520 | people who are taking out credit card debt, for example, to fund their business or fund their
00:10:43.840 | consumption, lifestyle. You know, these are kind of desperate folks who are going to be willing to
00:10:50.400 | pay 15% 20% 25% interest. I mean, that's ridiculous. And credit cards are making a killing.
00:10:55.840 | And also, this is the reason why I don't respect any company that makes money primarily off credit
00:11:00.960 | card sales or affiliate sales or whatnot. I think it's pretty shady and not really conducive to
00:11:06.240 | anybody's personal finances. And that's my little spiel there. So this ultimately hurts ends up
00:11:12.880 | hurting both the lender and the economy long term due to ultimately higher default rates. Right? If
00:11:18.400 | the least creditworthy people are borrowing because they need to borrow, they're desperate,
00:11:23.680 | you know, eventually, they're going to default on their loans. And this is going to cause a cascade
00:11:29.920 | of defaults. You know, if you look at 2007 to 2010, you saw plenty of overstretched mortgage
00:11:36.640 | debtors, just default short sale go bankrupt. And that really hurt not only themselves,
00:11:42.560 | but also everybody around them who didn't decide to default. So there will eventually be an
00:11:47.760 | interest rate inflection point where the borrower not only stops borrowing, but start saving more.
00:11:54.000 | Right? If the interest rates suddenly went to 10%, and it's probably because inflation is much
00:11:59.600 | higher, you're probably gonna be like, well, let's start saving a little instead of always investing
00:12:05.040 | because if I can get 10%, maybe the real rate of return is like 4%. Who knows? That's not bad.
00:12:11.200 | So with borrowers saving more investment by definition slows down. And you multiply this
00:12:16.400 | action across millions of people throughout the country, and the economy will turn south.
00:12:21.280 | And that's why I'm saying an inverted yield curve is a great predictor of an economic recession.
00:12:27.680 | And if you click over to the post, you will see over the past 35 years, within two years of the
00:12:33.040 | yield curve inverting, there was a recession every single time. So there are three times this happened.
00:12:39.760 | And every single time there was a recession. And when there's a recession, the stock market turns
00:12:43.840 | down, people lose their jobs, and things are not so good. So in economics and finance, everything
00:12:48.320 | is rational long term. Investors take action to enrich themselves while doing their best to avoid
00:12:53.680 | actions that will make them poor. It's kind of like wanting to get rich. If you want to get rich,
00:12:58.480 | you're not only going to work 40 hours a week, are you? And complain? No, you're going to work
00:13:03.360 | 60 hours, 70 hours, 80 hours, you're going to do double the work to get double the money while you
00:13:07.520 | still have the energy, you're going to think about ideas, side hustles, you're going to start an
00:13:11.040 | online business, whatnot. Right? This is rational action. And in finance, economics, everything is
00:13:16.320 | rational long term. So the tricky part is not forecasting if a recession will happen once the
00:13:21.600 | yield curve inverts. The tricky part is forecasting when the recession will happen. So my guess is the
00:13:28.800 | Fed raises its Fed funds rate by more than 50 base points over the next 12 months, the yield curve
00:13:34.000 | will most likely be inverted because the long end continues to stay the same. Therefore, the logical
00:13:40.080 | conclusion based on history is that a recession will arrive sometime between 2019 and 2020.
00:13:47.440 | Further, given the asset rise has been larger than ever before, since we're at record highs,
00:13:52.560 | it wouldn't be a surprise that the correction was also greater than ever before. So yes, definitely,
00:13:58.880 | absolutely. Banks have taken more measures to shore up their balance sheets, higher tier one
00:14:02.160 | capital ratio, tightening, you know, lending standards since the last recession. But we
00:14:07.120 | cannot underestimate greed. And this is banking greed, and also borrowers greed. And we can't
00:14:13.200 | underestimate the stubbornness of the Fed to over tighten to make sure that inflation gets stamped
00:14:18.160 | out. It's kind of like the bullwhip effect, you can't time it perfectly monetary policy. That's
00:14:23.520 | why you're always gonna be a little too early or too late. So everyone should be paying attention
00:14:28.480 | to a flattening yield curve over the next six months, definitely into 2019. And take precautionary
00:14:34.640 | measures to protect their wealth. So get a little bit more defensive in your portfolio, raise some
00:14:41.520 | cash, you know, cash yields are paying pretty well. And I'm going to talk about this in the next
00:14:45.680 | episode. It's much better to be a little bit too early protecting yourself than a little too late.
00:14:51.920 | Because once you want to protect yourself after the downturn hits, there are no bids, you know,
00:14:57.200 | nobody wants to buy anything, everybody's running for the hills. Thanks so much, everyone. I'd love
00:15:01.600 | to hear your thoughts. Do you think this time will be different? Will the long end of the yield
00:15:06.000 | curve begin to steepen as investors sell off safe assets for riskier assets? I don't think so. And
00:15:12.160 | when do you think the Fed will stop tightening? And when do you think the next recession will
00:15:16.000 | arrive? Something to think about, folks.