Hi I'm Jimmy
and this video.
I want to walk through the inverted yield curve.
What is an inverted yield curve
and why is it important.
Now let's start
with the result.
The theory is that when a normal
yield curve inverts
Well we may be heading towards a recession.
So that's the reason why
we look at it now since the 1990s
there've been three recessions in the United States
the Great Recession from the end of 2007
to about the middle of 2009
the dot com bubble during 2001
and then to kick off the 1990s
there was a recession then that came from
the savings and loan crisis.
Now that one ran from about mid nineteen
ninety to about March of nineteen ninety one.
So after we define the yield
curve and then the inverted yield
curve. Well I'm going to go through each of
the past three recessions to see
what the yield curve looked like back then
and then maybe we could find some similarities
with the way things look today.
So the first thing is what is the yield
curve. So basically the yield
curve shows yields
by maturity for a similar type
of investment.
You could have the yield curve for almost anything you could
do corporate bonds
and municipal bonds
or anything like that.
But the most popular one
is related to U.S.
Treasury bonds.
So here are the very basics for a normal
yield curve on the X axis
at the bottom.
We have time
and some of the most popular time periods
to look at our three month
yields six month yields two
years 10 years
and 30 years.
And then on the Y axis you have the
yield. So this is what a
normal yield curve looks like.
And the important thing for us to notice
when looking at a yield curve is
that the shape of the yield curve
notice that its upward sloping
and this makes sense if we think about it.
Don't forget that the yield over here.
Well this is how much an investor gets paid
for investing in a particular bond.
So in this example if we would invest
in a three month bond well we would get
paid a 3 percent annual rate.
And if we invest in a 10 year bond well
we get paid in this case a 6 percent
annual rate
and getting paid more money
for investing in longer term
investments makes sense since
in theory the longer you're in something
well the more risk there is
and the longer you have to lock up that capital.
So you should get paid a higher
rate of return.
So this brings us to the inverted yield curve.
So basically the inverted yield curve
is when the yield curve goes down.
So why is this bad
and how does this happen.
Well this is bad for banks.
So banks typically borrow on the short
end of the yield curve maybe that's
when maybe that's what you
or I get paid based for a savings
account. Well maybe that's what the bank borrows
from the Federal Reserve.
Basically what they pay out an interest
is based on short term rates.
That's why those rates tend to be so low when
they lend money they typically lend money
at longer term rates think mortgages.
So now they borrow money at
short term rates
and they lend out that money at long term
rates.
But if short term rates are higher
the long term rates it's going to
be very difficult for that bank to
lend profitably.
So what are banks do they
often stop lending.
And as we can imagine if they stopped lending
that's going to be a bad thing for the economy.
Now how does this happen.
So now let's switch this chart from an inverted yield
curve to a flat yield curve to demonstrate
how this might happen.
And it's important to remember
what happens when investors buy a bond
and how the yield is calculated.
So if we were to buy a bond
and that bond cost us one hundred dollars
and that bond is going to pay out three
dollars every year.
Well we take that three dollars we divide it
by the price we paid which is one hundred dollars
and we get a yield of 3 percent.
Simple enough.
But now what happens if a ton of investors start buying
a bond with just one maturity.
Well thanks to supply
and demand.
Well the price of that bond would start to move higher.
So what if the price instead of being one hundred dollars
was now one hundred twenty dollars.
We get the same three dollar interest
payment on an annual basis
but this time the cost is a hundred twenty dollars.
Say take three dollars
and you divide it by one hundred twenty dollars
and you get a 2.5 percent dividend
yield. And this is actually how you end up
with a normal yield curve.
See if the yield curve were to be flat.
Why would anybody invest in a 10
year bond or 30 year bond
when they could get the exact same rate of return
for investing in a three month bond.
See that's the most investors do.
In theory they sell the 10 year bond
and they buy the three month bond
a 10 year bond because it's getting sold
falls down the yields moves higher.
The three month bond more people pouring
into it pricing this higher yield
falls. So you end up
with a normal yield curve
and that makes sense.
Now there's also the impact of the Federal Reserve
and yes they have a big impact
on rates especially short term rates
but they don't actually set any of these
rates they actually set
overnight borrowing rates which
they call the fed funds rate.
And although they don't directly control
any of these rates they can have a big impact
on them by adjusting the fed funds
rate or shifting monetary policy
in one way or another.
If you're interested in learning more about the Fed funds
rate I have a link in the description below
for video I made on that.
OK. So ignoring the Fed
or monetary policy let's just leave
it to the impact of the market on these
rates. So what if people
or investors start looking for a safe
long term investments will call it a flight
to safety because they're worried about the market.
Well maybe investors want to lock up
their money for let's say 10 years.
So they go ahead and they start buying the 10 year
bond. And the price of those bonds
start to rise
and the price jumps to 120.
And the yield falls down to 2.5 percent
and then more investors pour in as
fear becomes more widespread
and the price climbs to 140
dropping the yield even further down to two
point one 4 percent
and so on.
So basically it's often
fear and a flight to safety
that causes the yield curve to invert.
So this brings us to the current yield
curve as we could see this
line is not nearly as clean as
the line in our examples
but if you saw some recent headlines
and the yield curve recently inverted.
Well this is what they're referring to.
Now many economists look at the
spread between three month
Treasury bonds
and 10 year Treasury bonds
and they look at that spread to determine
whether or not there is an inversion of the yield
curve right now.
If we invest in a three month Treasury bond
or we get two point four five percent
and if we invest in a 10
year Treasury bond we get 2.43
percent
and that spread means that
it's .02 percent negative.
Economists also use a two year spread
and a 10 year spread.
You can use either one.
And one thing I want to point out is that
all these interest rates you see there are always quoted on
an annual basis.
It's not 3 percent for
three months.
It is 3 percent over year divide by 4
with just a three month bond.
If I buy two of the six month bond.
So what does this mean for the economy
and for the stock market.
Well the first thing is there is a joke
that I've heard a few times that
that is that the inverted yield curve
has predicted 12 out of the last seven
recessions.
And basically this means that
just because the yield curve inverts
doesn't mean that there will be a recession.
It's been wrong before.
So if we go to the savings
and loan crisis of the early 1990s.
Well there was a recession
during that. That is a chart of the S&P 500.
That was a recession during that time.
And the yield curve inverted right here.
Now if we were to zoom in closer look at the yield curve.
This is what that looks like
and what they were paying attention to at the time was
the two year rate compared to the 10 year rate.
But if we were to flip back to the S&P 500
chart for a second we can see that the yield
curve inverted more than a year before
their eventual recession had.
Now jumping over the tech crash this is the
S&P 500 from that time.
And the economic recession happened right
here. And the inverted yield
curve came about right there.
Now I think it's important note that
you can really tell in this chart because it's pretty compact
but it was just short of the high
of the stock market when the yield curve actually
appeared. I also think it's important
that each of the yield curves are looking at
when they got there. They stayed there for it they
stay inverted for at least 10 days.
So this isn't just a quick dip into negative
territory and then they bounce back.
All of these examples stay there for at least 10
days although in this case the stock
market actually started to head lower shortly
after the inverted yield curve appeared.
But after the inverted yield curve
appeared it was a little bit of
time before the economy
went into a recession.
This is actually why they call in inverted
yield curve a leading economic indicator.
So this is what the yield curve looked
like back before the .com
bubble. And as we could see the 10
year bond and the 30 year bond are way
lower than the rest.
OK. Now on to the Great Recession.
So once again this is the S&P 500
during the Great Recession
and this is when the yield curve first
became inverted
and once again just like we saw in the early 90s
recession.
We can see that the stock market continued
to climb for quite some time
after the yield curve became inverted.
And this is what the inverted yield curve looked
like before the Great Recession
and we could see that the three month rates
and the six month rates well above
the 10 year rates
and 30 year rates.
So clearly this is a bad thing for banks
now jumping back to today's yield curve.
Well the answer is yes.
The 10 year rate is lower
than the three month rate
and this is a bad thing in my opinion.
What we need to do is we need to watch this
closely
and see how the shape of the yield curve
changes from a day to day basis
from a week to week basis.
So we saw in previous recessions
that there is no right
or wrong way for yield curve to
become an inverted yield curve.
And we also need to remember that just because
there is an inverted yield curve doesn't
mean this will always lead to a recession.
So we have to weigh as many factors as we can
but all recessions have
been preceded by an inverted
yield curve.
So for me I'm going to stick
with the same conclusion that I had in my
leading economic indicators video link
in the description below if you're interested
and that is that I believe it makes sense for us
to stay fully invested.
But I think it's also smart for
us to have some defensive holdings maybe
bulk those defensive holdings up
but what do you think.
Do you think that there is a recession it's
going to happen over let's say the next year
or two let me know what you think in the comments
below. Thank you for stick
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