11) Why does Wall Street love to talk about the Yield Curve?
Added 2022-12-24 16:53:32 +0000 UTCYou hear people on CNBC talk about this all the time.
But what does it ACTUALLY mean?
And what do they use this for?
After this read, you should gain a BETTER understanding.
It really is SIMPLE once you get to it.
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First, you need to understand the BOND market.
A BOND is a loan from an investor to a borrower such as a company or government.
The borrower uses the money to fund its operations, and the investor receives interest on the investment.
Bonds carry the PROMISE to return the face value(full amount) of the security(loan) to the holder at maturity(when times up).
But the DIFFERENCE between Bonds and Stocks is that stocks have no such PROMISE from their issuer.
When you purchase a stock, you're buying an actual share of the company. This makes you a partial owner.
Bonds, on the other hand, are DEBT.
When an entity issues a bond, it is issuing debt with the PROMISE to pay interest for the use of the money.
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Now there are DIFFERENT types of Bonds:
# Corporate Bonds
# Treasury bonds
# Mortgage-Backed Bonds (MBS)
In this case, we will look at Treasury bonds also known as Government Bonds which are just loans to the FEDERAL GOVERNMENT.
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The Treasury Yield.
The TREASURY is usually the government.
YIELD is the INTEREST return on investment.
The TREASURY YIELD is the interest rate that the U.S. government pays to borrow money for different lengths of time.
These are considered the LOWEST-RISK investments because they are backed by the full faith and credit of the U.S. GOVERNMENT.
The Government can increase TAXES to pay for this loan back to you.
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You hear people talk about these in different forms.
They may sound CONFUSING at first,
but Wall Street use this TERMINOLOGY to make it seem as if only they can do what they do.
Stay FOCUSED.
Treasury yields:
- Treasury Bills (T Bills)
- Treasury Notes (T Notes)
- Treasury Bonds (T Bonds)
These are all loans to the government but the only DIFFERENCE is the amount of TIME you loan for.
They also use a fancy word called MATURITY.
MATURITIES here refer to the date on which the life of the transaction ends.
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If you give a loan to the government for £5000 for 6 months, you will get a T-BILL, which says you will get your loan back with interest after 6 months.
If you give a loan to the government for £5000 for 6 years, you will get a T-NOTE, which says you will get your loan back with interest after 6 years.
If you give a loan to the government for £5000 for 16 Years, you will get a T-BOND, which says you will get your loan back with interest after 16 years.
They have different TIME RANGES.
Treasury yields:
- T BILLS: 1month - 1 Year
- T NOTES: 1 Year - 10 Years
- T BONDS: 10+Years
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Now let's discuss the Yield Curve.
The YIELD CURVE is a graph that plots yields (interest rates) of the above government bonds that have different maturity dates.
The SHORTER the duration you are loaning to the government, the LESS interest you SHOULD receive.
Why?
Because you are taking on LESS RISK as only so much can happen in a month.
Whereas the person loaning out to the government for 10+ years (T-Bonds) is taking a HIGHER RISK because anything could happen.
Inflation could rise, Dollar could collapse, and you might be missing out on BETTER investments.
IN GENERAL, you expect LESS interest for a shorter duration in comparison to someone who is loaning for a longer duration.
So the graph below shows what a NORMAL yield curve should LOOK like to see what type of return they are getting when they lend money to the government.
It is important to mention that the yield is ANNUALISED and is expressed as an annual rate.
That LINE is called the yield curve.
Simple isn't it?
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What determines this Yield Curve?
When the government needs to BORROW money, let's suppose they need to borrow a Billion in 1 Year's notes, people go and AUCTION those T notes.
If there are a lot of people who want to BUY these notes, then the YIELD RATE will FALL as there's a lot of DEMAND and people want to BUY it.
Similarly, if the people DON'T want to loan to the government and want to INVEST elsewhere, then the treasury(government) has to INCREASE the yield rate.
The government does auctions for all these different durations.
Remember that Government Bonds are low risk, so if people WANT to buy them, the economy isn't doing well.
If people DON'T want to buy them, then the economy is doing WELL as investors are getting higher returns elsewhere.
You can EASILY see how the RETURN RATE can tell us how GOOD or BAD people think the economy is doing.
So supply and demand of the yield curve can tell us what people think of the economy.
Let's see how WALL STREET uses this.
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Types of Yield Curves:
There are THREE TYPES of the yield curve,
1. Normal
2. Flat
3. Inverted
The NORMAL yield curve is shown below.
As it starts with LOW yields for shorter-maturity bonds and then INCREASES for bonds with a longer maturity, sloping UPWARDS.
A NORMAL yield curve means STABLE economic conditions.
This implies to us that the economy is GROWING and stable (economic expansion).
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The FLAT yield curve is shown below.
A FLAT yield curve is defined by similar yields across ALL maturities.
Simply put,
when a flat yield curve exists, investors get the same amount of money for short-term bonds as they do for long-term bonds.
It often signals UNCERTAINTY in the market and could make investors WARY.
Such a curve could mean investors are STARTING to lose faith and confidence in the economy's long-term growth outlook.
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The INVERTED yield curve is shown below.
When the return for SHORTER-term maturities are HIGHER than those for LONGER-term maturities, that creates an INVERTED yield curve.
This can indicate a RECESSION.
HOW?
As mentioned previously, the 10-year government bond is believed to be the SAFEST asset in the world.
Now when uncertainty in markets INCREASES, everyone runs to BUY these assets.
DEMAND bids the price up and yields DECREASE.
So we can look at this graph and if we see a decline in 10-year yields then we know the economy is perceived as WEAK,
as lots of people are trying to buy this SAFE asset, hence why yields FALL.
This inverted yield curve has predicted many recessions in the last century.
An inverted yield curve, where short-term rates are higher than long-term rates, led to a recession within 12 to 18 months.
Most people look at it wrongly.
Let's plot the charts for CURRENT yield rates.
The website is:
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Don't let the number SCARE you!
We will look at the date 12/22/2022.
You do not need to plot all months, but the most common ones Wall Street use is the 10-Year VS 3 Months.
In a STABLE ECONOMY, the 10-year treasury should give a HIGHER yield return than the 3 month treasury.
But what do you notice?
3 Month yield rate = 4.34%
10 Year yield rate = 3.67%
If we were to plot this on a graph, then it would show the YIELD CURVE HAS INVERTED!
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Now, most people would indicate this as a recession.
But looking at the chart below,
it has BRIEFLY INVERTED many times in the past WITHOUT economic recessions also.
So to get a QUALITY indication:
I argue a yield curve inversion must be realised for a FULL QUARTER - not merely a few days,
and it needs to remain inverted for multiple quarters to count as a TRUE indicator.
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Hopefully, you made it to the end and realised that it's actually pretty SIMPLE.
You do not need an MBA or a UNIVERSITY DEGREE to understand this.
Just a passion for learning and a dying desire to win.
That's all.
@ionicXBT
