Welcome back.
Before we proceed further and get a little bit better
understanding of why maybe some of these investors were
so keen on investing in mortgage backed securities,
essentially loaning this money to all these people who are
buying these ever appreciating houses, I think we need to a
few more tools in our tool belt.
So I'm going to introduce you to the concept
of the yield curve.
You might have heard this before.
You might have heard people on CNBC talk about it.
And hopefully, after about the next five or ten minutes, you
will know a lot about the yield curve.
So when most people talk about the yield curve, they're
talking about the treasury yield curve.
And what does that mean?
What is even a treasury?
So these treasury securities, whether they're T-Bills,
treasury bills, treasury notes, or treasury bonds.
These are loans to the federal government.
And these are considered risk-free.
Because if you lend to the federal government and they're
running short of cash, all they have to do is increase
taxes on us the people and they can pay back your debt.
So in dollar denominated terms, the treasury bills,
notes, and bonds are about as safe as you can get in terms
of lending your money to anyone.
So when most people talk about the yield curve, they're
talking about the risk-free yield curve.
And they're talking about the curve for treasuries.
So first, a little bit of definitions.
What is the difference between treasury bills, treasury
notes, and treasury bonds?
They're pretty much all loans to the government.
But they're loans for different amounts of time.
So if I give a loan to the government for $1,000 for six
months, that will be a treasury bill.
So I will give the government $1,000, the government would
give me a treasury bill.
And that treasury bill from the government is essentially
just an IOU saying that I'm going to give you your money
back in six months with interest. Similarly, if it's
three months, it's a three month treasury bill.
Treasury notes are loans that are from one year to 10 years.
So on this graph that we're going to make using the actual
yield curve rates, from zero to one year-- and actually
there's no zero year treasury bill.
Actually, the shortest one is one month.
This would be something like here on our graph.
So from one month to one year, these are T-bills.
And this is just definitional.
Then from one year to 10 year, these are notes.
Actually, I believe the one year itself is a note.
Up to one year is a bill.
Although, I might be wrong with that.
Correct me if I'm wrong.
That's just a definitional thing.
From one to 10 year, these are called notes.
And then when you go beyond 10 years, these are called
treasury bonds.
These are just definitional things to worry about.
So with that out of the way, let's talk about what the
yield curve is.
I'll just give you a simple thought experiment.
If I'm lending money to someone for a month versus
lending money to that person for a year, in which situation
am I probably taking on more risk?
Well, sure, if I'm lending someone for a month, I know
only so much can happen in that month.
So I would expect to be paid less interest. Not just
obviously in dollar terms, but even adjusted for time, I
would expect less interest for that month.
And this is actually an important point to make.
When I say that I'm charging 6% interest for that month,
that doesn't mean that after a month the person is going to
pay me 6% on my money.
It means that if I were to give that money to somebody
for a month, and they were to pay it back.
And then I were to give that money to, say, that same
person, or another person, for a month, and I were to keep
doing that for a year, then in aggregate I would get 6%.
So that 6%, no matter what duration we talk about,
whether one month, one year, five years, 15 years, when we
talk about the interest rate, that's the rate that on
average we would get for a year.
It's the annualized interest rate.
So going back to my question.
If lend someone money, even the government, for a month,
there's usually less risk in that.
Because only so much could happen in a
month versus in a year.
In a year there might be more inflation, the dollar might
collapse, I might be passing on better investments, I might
need the cash in a year's time, while I have a lot of
confidence that I don't need the cash in a month's time.
So in general, you expect less interest when you loan money
for a shorter period time than a longer period of time.
And so let's draw the yield curve and see
if this holds true.
So I actually went to the treasury
website, so that's treas.gov.
And this is the yield curve.
So they say on March 14, so this is
the most recent number.
And I'm going to plot this.
They say, if you lend money to the government for one month,
you'll get 1.2% on that money.
And remember, if it's $1,000 it's not like I'm going to get
1.2% on that $1,000 just after a month.
If I kept doing it for a year, this is an annualized number,
I'll get 1.2%.
And so for three months, I get a little bit less.
And then for six months I get more.
And then it does seem that the overall trend is that I expect
more and more money as I lend money to the government for
larger and larger periods of time.
And this is a little interesting anomaly that you
get a little bit more interest for one
month than three months.
And we'll do a more advanced presentation later as to why
you might get lower yields for longer duration investments.
That's called an inverted yield curve.
So let's just plot this and see what it looks like.
So you saw where I got my data.
So they say for one month I'd get 1.2%.
So this is one month.
It'd be right about here.
Three months I get about the same thing.
For six months I get 1.32%.
Maybe that's like here.
One year, I get one 1.37%.
Maybe it's here.
Five years, I get 2.37%.
So that's maybe like here.
And these aren't all of the durations.
I'm just for simplicity not going to do all of them.
For 10 years, 3.44%.
So maybe that's here.
For 20 years, I get 4.3%.
Like that.
And then for 30 years, I get 4.35%.
So the current yield curve looks something like this.
And so you now hopefully at least understand what the
yield curve is.
All it is, is using a simple graph.
Someone can look at that graph and say, well, in general what
type of rates am I getting for lending to the government?
On a risk-free free basis, or as risk-free as anything we
can expect, what type of rates am I getting when I lend to
the government for different periods of time?
And that's what the yield curve tells us.
And in general, it's upwardly sloping.
Because, as I said, when you lend money for a longer period
of time, you're kind of taking on more risk.
There's a lot more that you feel that could happen.
You might need that cash.
There might be inflation.
The dollar might devalue.
There's a lot of things that could happen.
So the next question is, well, what
determines this yield curve?
Well, when the treasury, the government, needs to borrow
money, what it does is say, hey everyone we need to borrow
a billion dollars from you, because we
can't control are spending.
And they say we're going to borrow a billion dollars in
one month notes.
So this is one month notes.
They're going to borrow a billion dollars.
And they have an auction.
And the world, investors from everywhere, they go in, they
say, well, this is a safe place to put
my cash for a month.
And depending on the demand, that determines the rate.
So if there are a lot of people who want to buy those
one month treasuries, the rate might be a little bit lower.
Does that make sense to you?
Think about it.
If a lot of people want to buy it, there's a lot of demand
relative to the supply.
So the government has to pay a lower interest rate on it.
Similarly, if for whatever reason people don't want to
keep their money in the dollar, they think the U.S.
might default on their debt one day, and not that many
people want to invest in the treasury, then that auction,
the government is going to have to pay a higher interest
rate to people for them to loan money to it.
So maybe then the auction ends up up here.
And similarly, the government does auctions for all of the
different durations.
And duration, I just mean the time period you're
getting the loan for.
So they do it for one month, three months, six months, one
year, two year, three year, et cetera.
Once the government has done that auction-- You give the
money to the government, they give you an
IOU called a T-bill.
Then you could trade it with other people.
And that's going to determine the rate in the short term.
So the government does the auction.
But then after the auction, and a lot of people had
demand, but then a lot of people get freaked out.
And the public markets, when you try to sell that treasury,
will then expect.
a higher yield.
I know that might be a little complicated now.
And I always start to jumble things when I run out of time.
But hopefully at this point you have a sense of what the
yield curve is.
You have a sense of what treasury bills, treasury
notes, and treasury bonds are.
And you have some intuition on why the yield
curve has this shape.
See you in the next video.