Hello everybody, it's Sam from Financial Samurai and I thought it would be a good idea to talk about the yield curve, which I think is one of the best economic predictors. So you may be hearing more about the yield curve lately because the yield curve is flattening out. And I just wanted to use this podcast to explain why the yield curve is important and why an inverted yield curve is a clear sign of an upcoming recession.

Now some people say, well, this time it's different. I want to say that this time is not different because investors are rational. All of us are rational because we want to do things to make us more money and do less of the things that could lose us money. The yield curve is a curve on a graph in which the yield of fixed interest securities is plotted against the length of time they have to run to maturity.

So for example, treasury notes, you know, one month note, three month note, six month note, 12 month note, those are the short end and then the longer end, three year, five year, 10 year, 30 year. So the yield curve is almost always upward sloping, which is a sign that the economy is functioning properly.

And to best understand the yield curve, all you've got to do is put yourself in the shoes of the lender, the borrower and the investor. Each entity is rational and looking to do what's best for their bottom line. So let's start with the lender's perspective. Due to inflation, the value of a dollar tomorrow is worth less than the value of a dollar today.

Hence, in order to profitably lend money, you must charge an interest rate. And the longer the lending term, the higher the interest you should charge, hence the upward slope of the yield curve. Now, if the borrower has a poor credit score, is not a Financial Samurai podcast listener, runs an unstable business, has like a three year gap year where he or she had no job, you're probably going to need to charge an even higher rate to account for credit risk.

If you can get a borrower to pay back an interest rate higher than your competition, you're making a superior economic return. And this is exactly what banks do. They have complex models, actuaries, all these people trying to figure out risk, and hopefully they can lend enough money at a high enough volume with a high enough spread to make a profit.

So your main source of funding as a bank is from savings deposits. And this is the shortest term. So that's why over the past several years, your money market account only pay like point 1% to point 5%. Banks were loving it because they didn't, they didn't have to pay you the money, they could just pay such a low interest rate.

And then they could turn around and lend it for a higher interest rate. So that is what a bank does. They take in your deposits, pay you a small rate, and hopefully re-lend that money at a higher rate to earn a positive net interest margin gain. So the yield curve is upward sloping, banks have an easier time achieving such profitability.

Now from a borrower's perspective, a rational borrower is incentivized to borrow as much money as possible for as long a period of time as possible at the lowest interest rate possible to get rich. Now, the more you borrow, the more you will likely invest. And when the borrowing rate is equal to or below the inflation rate, a borrower is essentially getting a free loan.

So back in 20 around 14, I was able to lock in an adjustable rate mortgage of 2.375%. And that was great because the 10-year bond yield was at about 2.35% as well. It was probably more like around 2.1%. But now the 10-year bond yield is at 2.85%. So I've essentially locked in several more years of an interest rate that is below inflation.

So I'm actually borrowing money for free while the asset price goes up. So that's pretty sweet, right? So the classic borrower example is the homebuyer. After putting 20% down, the buyer borrows the remaining 80%. The lower the interest rate, the more inclined the borrower is to take on more debt to buy a bigger and fancier house.

And when homebuyers really needed to stretch, they took out short-term adjustable rate mortgages. So you had a one-year adjustable rate mortgage, three-year and five-year. Those are the most common compared to a 30-year fixed loan with higher rates. Now, I've been a proponent of taking out an adjustable rate mortgage since 2009.

Because if you look at the history of interest rates, they've been going down since the late '80s. So in a declining interest rate environment, taking out an arm is an optimal move. But in a rising interest rate environment, you may get a little bit squeezed once the arm resets.

But I still think we're in a lower-for- longer interest rate environment. It's just recently we've come off from the very lows of the lows, and we're kind of ticking up. But I don't think it's going to go that much higher. So in addition to homebuyers, there are companies, large and small, that borrow money to grow their respective businesses.

If interest rates are lower at every duration, businesses will tend to borrow more, invest more, hire more, and consequently boost GDP growth. So the equation for GDP growth is y equals c plus i plus g plus nx. So c is consumer spending, i is investment, g is government spending, and nx is net exports.

So the i is very important in GDP growth. And when interest rates are low, that spurs more investments. Now let's look at the investor's perspective. Given the motivations of the borrower and the lender, the investor sees the yield curve as an economic indicator. The steeper the yield curve, up to a point, the healthier the economy.

I say up to a point because if it's super steep and super high, it's probably not a good economic environment because there's inflation, maybe hyperinflation, and higher interest rates will choke off growth. The flatter the yield curve, the more cause for concern given the borrower's doubt about the near future.

So if there's a lack of demand for short-term bonds, pushing short-term yields higher, perhaps there is doubt about short-term economic growth. We know that the average recession lasts 18 months. So if that's the case, maybe you don't want to really invest in anything over the next two years. Similarly, if investor demand for long-term bonds keeps long-term yields low, this may mean investors don't believe there are inflationary pressures because the economy isn't viewed as trending stronger.

If the long-term view of the economy is, you know, even tighter job market, even stronger corporate earnings, even more competition, and so forth, that's inflationary. And if that's inflationary, people aren't going to want to hold bonds. They want to hold assets that inflate with inflation or hopefully faster than inflation.

Short-term yields are also artificially pushed up by the Federal Reserve since the Fed Fund rate is the overnight banking lending rate. And that's the shortest of the short, right? Overnight rate. An investor needs to make a calculated guess as to how often and how aggressively the Federal Reserve will raise their Fed Funds rate and how the bond market will react to such moves.

The bond investor wins if inflation comes in below expectations. Inflation comes in below expectations when economic growth comes in below expectations. And the stock market investor wins if economic growth comes in above expectations, generating stronger corporate earnings growth, while interest rates remain at a level high enough to contain faster than expected inflation, while not choking off investment growth.

So the Federal Reserve targets about a 2 to 2.3% annual CPI inflation. And whenever it's trending higher than that, they'll tend to raise rates further. And when it's trending below that, they'll tend to cut rates. So right now we're at about 2%. We're kind of at this natural rate of unemployment and inflation level.

So I think that's pretty good. But we shall see about the future, because nobody knows except for them. And not even they know what the economic future will lie. They're making best case guesstimates themselves. So if you look at the yield curve over the past three years, it is definitely flattened because the long end has not risen as fast as the short end, right?

Because the Fed has been raising rates, I think, since end of 2016. So the long end, like the 10-year bond yield, for example, did come from a low of about 1.6%, 1.8%, and now it's at about 2.8%. But the short end has risen even further, hence the flattening. So if the Fed raises the Fed funds rate by another half a percent or 50 basis points in the next 12 months, the yield curve will be completely flat, if not inverted by 2019, if long term rates stay the same.

And I definitely recommend you go over and click to the post and check out these awesome graphs. And with a flat yield curve, you're disinclined to lend money over a long duration because the return is too low relative to the short end. As a result, you tighten up lending standards and lend to only the most creditworthy people.

And that's kind of the irony. Over the past five, six, seven years since the financial crisis, only the highest creditworthy people got loans, and probably only the people who really didn't need a loan got loans, and the most desperate people were shut out. And as a lender, you'd rather lend money for as short a time as possible because the interest rate you receive is similar to the long end.

That makes sense. And shorter lending time horizon is also less risky than longer time horizon, right? You don't, it's hard to predict 10 years from now what's going to happen. But it's much easier to predict what's going to happen in the next six to 12 months. So unfortunately, for borrowers, they think exactly the opposite.

The borrowers are less inclined to borrow capital short term if the interest rate is very similar to long term interest rates. They'd rather borrow at the same rate for a longer time period, but they're often shut out due to more stringent lending standards. If the yield curve inverts, or in other words, when the short term interest rates are higher than long term interest rates, the rational borrower slows or stops his or her borrowing.

Only the most desperate, desperate least creditworthy borrower takes out a short term loan at a higher interest rate. So just think about all those people who are taking out credit card debt, for example, to fund their business or fund their consumption, lifestyle. You know, these are kind of desperate folks who are going to be willing to pay 15% 20% 25% interest.

I mean, that's ridiculous. And credit cards are making a killing. And also, this is the reason why I don't respect any company that makes money primarily off credit card sales or affiliate sales or whatnot. I think it's pretty shady and not really conducive to anybody's personal finances. And that's my little spiel there.

So this ultimately hurts ends up hurting both the lender and the economy long term due to ultimately higher default rates. Right? If the least creditworthy people are borrowing because they need to borrow, they're desperate, you know, eventually, they're going to default on their loans. And this is going to cause a cascade of defaults.

You know, if you look at 2007 to 2010, you saw plenty of overstretched mortgage debtors, just default short sale go bankrupt. And that really hurt not only themselves, but also everybody around them who didn't decide to default. So there will eventually be an interest rate inflection point where the borrower not only stops borrowing, but start saving more.

Right? If the interest rates suddenly went to 10%, and it's probably because inflation is much higher, you're probably gonna be like, well, let's start saving a little instead of always investing because if I can get 10%, maybe the real rate of return is like 4%. Who knows? That's not bad.

So with borrowers saving more investment by definition slows down. And you multiply this action across millions of people throughout the country, and the economy will turn south. And that's why I'm saying an inverted yield curve is a great predictor of an economic recession. And if you click over to the post, you will see over the past 35 years, within two years of the yield curve inverting, there was a recession every single time.

So there are three times this happened. And every single time there was a recession. And when there's a recession, the stock market turns down, people lose their jobs, and things are not so good. So in economics and finance, everything is rational long term. Investors take action to enrich themselves while doing their best to avoid actions that will make them poor.

It's kind of like wanting to get rich. If you want to get rich, you're not only going to work 40 hours a week, are you? And complain? No, you're going to work 60 hours, 70 hours, 80 hours, you're going to do double the work to get double the money while you still have the energy, you're going to think about ideas, side hustles, you're going to start an online business, whatnot.

Right? This is rational action. And in finance, economics, everything is rational long term. So the tricky part is not forecasting if a recession will happen once the yield curve inverts. The tricky part is forecasting when the recession will happen. So my guess is the Fed raises its Fed funds rate by more than 50 base points over the next 12 months, the yield curve will most likely be inverted because the long end continues to stay the same.

Therefore, the logical conclusion based on history is that a recession will arrive sometime between 2019 and 2020. Further, given the asset rise has been larger than ever before, since we're at record highs, it wouldn't be a surprise that the correction was also greater than ever before. So yes, definitely, absolutely.

Banks have taken more measures to shore up their balance sheets, higher tier one capital ratio, tightening, you know, lending standards since the last recession. But we cannot underestimate greed. And this is banking greed, and also borrowers greed. And we can't underestimate the stubbornness of the Fed to over tighten to make sure that inflation gets stamped out.

It's kind of like the bullwhip effect, you can't time it perfectly monetary policy. That's why you're always gonna be a little too early or too late. So everyone should be paying attention to a flattening yield curve over the next six months, definitely into 2019. And take precautionary measures to protect their wealth.

So get a little bit more defensive in your portfolio, raise some cash, you know, cash yields are paying pretty well. And I'm going to talk about this in the next episode. It's much better to be a little bit too early protecting yourself than a little too late. Because once you want to protect yourself after the downturn hits, there are no bids, you know, nobody wants to buy anything, everybody's running for the hills.

Thanks so much, everyone. I'd love to hear your thoughts. Do you think this time will be different? Will the long end of the yield curve begin to steepen as investors sell off safe assets for riskier assets? I don't think so. And when do you think the Fed will stop tightening?

And when do you think the next recession will arrive? Something to think about, folks.