In the world of investments, there's this saying: "When Bonds speak, you listen." It speaks to the bond market’s uncanny ability to predict the macroeconomic climate and investment markets. Recently, "the bond market has spoken" once again. The yield on the U.S. 10-year Treasury has neared 5% for the first time since 2007, sending ripples of tension across the investment landscape. Are we on the brink of an economic recession? In today’s video, I’d like to delve into what these recent changes in the bond market mean for the economy and your investments. This is a famous curve often used to predict a U.S. economic recession. The horizontal axis represents time, while the vertical axis shows the difference between the U.S. 10-year and 2-year Treasury yields. Under normal circumstances, this difference is greater than zero, placing it above the horizontal line. When this difference falls below 0, meaning long-term yields are less than short-term yields, we refer to it as a yield curve inversion. This is a perilous signal, for historically, nearly every time it has occurred, the U.S. has been on the cusp of an economic recession. I delved into this phenomenon in detail in March 2022, "Now, in March of 2022, we find ourselves here." "Does this mean we’re on the verge of an economic downturn?" “Now, it’s here. Does this mean an economic downturn is imminent?” To date, the inversion has lasted for over a year, and the recent accelerated increase in the 10-year Treasury yield has pushed this difference from the negatives back toward zero, gradually unwinding the inversion. Pay attention, most of the economic recessions in history occurred after the yield curve normalized. So, if we were to liken an economic recession to a storm, the period of my last video was like a weather forecast 7 days in advance. And now, it’s as if the dark clouds are gathering just before the storm hits. This curve seems to be turning back to "normal", but what it represents is actually the height of "abnormal." It is precisely the signal of an economic recession that we should truly be wary of. And right now, we find ourselves at this very moment. So now, let’s take a good look and dissect what this curve is really telling us about the economy and what it means for your investments. As we’ve just discussed, this curve represents the difference between the yields of two bonds. And the resolution of the inversion is this process of the difference going from negative to positive. So, there are two possibilities for this to occur: either the yield on the 2-year bond falls faster, or the yield on the 10-year bond rises faster. This is the stage we are currently in. Both scenarios are troubling, but they indicate different economic phases. Let’s first consider the first scenario: A rapid decline in short-term yields leading to the resolution of the inversion often signifies that the majority of investors are expecting an imminent recession. They believe the Federal Reserve will soon cut interest rates to stimulate the economy. I know this might sound a bit perplexing: Aren’t we talking about “expectations” here? Hasn’t the Fed started cutting rates yet? So why are short-term bond yields falling on their own? Firstly, we need to understand that when the Fed cuts interest rates, they are cutting the “Federal Funds Rate,” which directly affects short-term interest rates. So, when people expect the Fed to cut rates, they are actually anticipating a drop in short-term interest rates. Understanding this helps us make sense of it all. Let's take an example, right now, the interest rate for a 3-month bond is 5.58%, imagine, if you're predicting that the Federal Reserve is going to cut rates next month, bringing this yield down to 3%, what would you do as an investor? Wouldn't you seize the moment while the interest is high, and buy as much as you possibly can? I've talked in previous episodes about a crucial characteristic of bonds, that is, as prices rise, yields fall; conversely, as prices fall, yields rise. Remember this feature, as we will use it frequently. So, when the market broadly anticipates that the Federal Reserve is about to cut rates, everyone rushes to buy short-term bonds to lock in high interest rates. This, in turn, pushes up bond prices, leading to a sharp decline in short-term yields. This is the first scenario of yield curve inversion. You might wonder, “How can these bond investors be so savvy? To actually predict an impending economic recession? ” Well, it's not as mysterious as it seems. When we say "the bond market speaks," what we are really referring to is the collective expectation of the majority of bond investors manifesting in the market. And this "majority" is crucial. You could think of the bond market as the voting result of the majority of investors on their economic expectations. If we cast a glance, and see businesses folding, job cuts multiplying, and people starting to default on their mortgages, even banks starting to have issues, then, it would be clear even to the layman that an economic crisis is upon us. The Federal Reserve would need to cut rates to stimulate the economy, and this is reflected in the bond market as the first scenario we discussed. So why are we not in that scenario right now? Because the current economic data is not entirely pessimistic. Employment rates are stable, and consumer activity is still brisk. Not just us ordinary folks, even the so-called experts are hesitant to declare an imminent major economic downturn. So, the first scenario is not happening for now. We find ourselves in the second scenario, where the yield curve inversion is being undone by a faster rise in the yields of 10-year government bonds. This situation tends to be a bit tricky. Why, you ask? Here’s a trend chart of the 10-year government bond yields over the past decade or so. Investment markets pay particular attention to the 10-year government bond yields because they often serve as a benchmark for many long-term interest rates, such as mortgages and long-term corporate borrowing. Starting from 2008, it has remained at a low level of around 2.5%. This prolonged period of low interest rates has led companies and individuals to get accustomed to rolling over their debt, accumulating a substantial amount of liabilities. But starting from June 2020, the yield soared all the way to the current 5%. This not only means that the cost of new financing has risen, but those companies and individuals laden with substantial debt will face higher repayment pressures. If they cannot adapt, this could potentially trigger more defaults, job cuts, and even bankruptcies. High interest rates pose a significant threat to banks and the financial system. Over the past decade or so, banks have accumulated a substantial amount of U.S. long-term government bonds. This was a relatively safe bet, as interest rates remained consistently low, keeping the value of these assets fairly stable. But, as we’ve seen, when interest rates suddenly rise, the value of these bonds can quickly decrease, potentially leading to significant capital losses for the banks. This, in turn, affects their capital adequacy ratios, and if enough banks are hit at the same time, it could lead to a domino effect, resulting in a tightening of credit and potentially a financial crisis. We’ve seen a glimpse of this with the collapse of Silicon Valley Bank earlier this year and the U.K.'s pension fund crisis last year. If the yields on 10-year Treasury bonds continue to rise, there’s a risk that more banks and financial institutions could find themselves in hot water. Now, let’s not forget our debt-laden U.S. government. The country's debt now exceeds a staggering 33 trillion dollars, and it’s expected to borrow an additional 2 trillion dollars on average each year over the next decade. What’s more troubling is that about half of these new borrowings are expected to go towards paying interest on existing debt. And with the U.S. political parties frequently playing high-stakes games over the debt ceiling, a disagreement could easily lead to a government shutdown. While the likelihood of a debt crisis triggered by a U.S. government default is low, these instabilities raise concerns about the long-term international status of the U.S. dollar. So, while the first scenario of the curve inversion that we talked about earlier signals an upcoming recession, our current situation, the second scenario, comes with a lot more ambiguity: It's unclear whether a recession is imminent, but the financial situation has undoubtedly become more complex and perilous. The Fed’s policies of raising interest rates are finally trickling down to all facets of the economy, and people are starting to feel the acute pain that comes with higher interest rates. Well, what exactly has led to the sharp rise in the yield of 10-year Treasury bonds? We all know that prices are often determined by the relationship between supply and demand. Bonds are no exception. Remember what we just talked about, that when the price of bonds falls, the yield rises, right? So now, with the yield on the 10-year Treasury bond going up, it indicates that there are fewer buyers. Supply exceeds demand. This causes the price to fall and the yield to rise. Specifically, there are four major reasons for this change in supply and demand. First, the structure of Treasury bond buyers has changed. Since 2008, the biggest buyers of U.S. debt have been the Federal Reserve, foreign governments like China, and U.S. commercial banks. These buyers are flush with cash, especially the Federal Reserve. It can literally print money infinitely. For instance, during the pandemic, the Federal Reserve initiated unlimited quantitative easing to stimulate the economy, buying U.S. Treasury bonds in unlimited quantities. No matter how much the government issued, it could buy. At that time, buyers far outnumbered sellers, leading to an increase in bond prices and a decrease in yields. This is why U.S. Treasury bonds have maintained low interest rates for the past decade or so. But now, these major buyers have backed off. The Federal Reserve has started to unwind its balance sheet, reducing the scale of U.S. Treasury bond purchases. China's economy has also encountered problems. It’s doing well if it’s not selling U.S. Treasury bonds. When buyers decrease, it leads to a drop in bond prices and an increase in yields. As for commercial banks, due to the reasons we've just discussed, they're almost drowning in the U.S. Treasury bonds they hold and are even less willing to buy more. So, now that these top buyers have backed off, the main buyers have become financial institutions like hedge funds. They certainly don’t have the deep pockets of central banks. When they invest, they do so with a sharp pencil and a keen eye. In the present climate, to attract them to long-term U.S. Treasuries, you need to offer a higher interest rate. There are simply more attractive investments available on the market. And that brings me to the second reason I was about to mention. 2. Better investment options have led to a decrease in demand for long-term U.S. Treasuries, resulting in higher yields. I believe many of you, like me, have unprecedentedly started keeping your cash in short-term fixed deposits for a few months to a year. This kind of investment, offering high interest for a short time and low risk, is seen by many as a better option than long-term government bonds. Apart from bank deposits, there are plenty of high-interest cash management ETFs on the market. They distribute interest regularly and allow you to redeem at any time, and you can get your principal back easily – much more convenient than buying government bonds. And that’s not all. Now even brokerage firms have started paying interest, like my channel’s long-term sponsor, Interactive Brokers. OK, I’d like to take a moment to extend my gratitude to IB for their longstanding support. IB is the brokerage firm I personally use, it’s incredibly professional and powerful. The experience is stellar. In many regions, they operate without any commission fees, or the fees are so low they hardly make a dent. As someone who often buys U.S. stocks from Canada, converting CAD to USD, I find IB’s currency exchange to be exceptionally fast and affordable. Compared to Canadian brokers that easily charge upwards of 1.5% in fees, IB’s currency exchange cost is significantly lower. This alone is reason enough for me to choose them. And now, IB even pays competitive interest on the cash sitting in your account, which is a great advantage for investors. You can let your cash accrue interest while waiting for the right investment opportunity, and when it arrives, you can invest right away, without losing time in funding your account. I highly recommend checking out Interactive Brokers through the link in the comments section. If you do, it helps me out, and it's a way to back what I do! Alright, let’s dive back into our video. These high-interest, short-term, low-risk cash deposit-like investments have attracted a torrent of capital. This has led to a diminished demand for long-term bonds, driving their prices down and yields up. Now, you might be wondering, isn't this counterintuitive? Isn't this situation somewhat akin to the first scenario we discussed about yield curve inversion rectification? Where everyone is flocking to invest in these high-interest short-term debts, why hasn’t it led to an increase in their prices and a decrease in their yields? The answer lies in the peculiarities of the market. This is because we have a seller in the market, seemingly indifferent to costs, propping up these elevated short-term rates. You might have guessed it; this seller is none other than the Federal Reserve. Now, let’s talk about the third reason long-term Treasury yields are going up. It’s like this: the Federal Reserve’s policies of hiking interest rates have finally permeated every corner of the market. As we just discussed, the Fed’s moves to raise or lower rates directly affect short-term interest rates. I’ve gone into detail about this in a previous video, but to put it simply, the Fed is like a bank for banks. We deposit our money in banks, and the banks deposit their money with the Fed. The Fed pays the banks interest, and this is known as IORB. By raising this IORB, the banks receive a higher short-term interest rate, which they can then pass on to their customers in the form of higher interest on deposits, while also charging higher rates to those borrowing money. In this way, the Fed manages to extend the increase in short-term rates throughout the whole of the economy’s activities. Now, where does the Fed get the money to pay interest to the commercial banks? In simplistic terms, if the Fed can create money out of thin air, it can also lose money out of thin air. The money the Fed uses to pay interest mainly comes from the interest earned on the Treasury bonds it has purchased before. But the money is not enough to pay the banks at the moment, so, the Fed uses a special kind of accounting method that allows it to keep paying high interest even while it’s losing money. If it were a regular company, it would have gone bankrupt by now, but the Fed is a central bank, operating under a different set of accounting rules. We won’t delve into that here. So, when there is a mega-seller in the market capable of affording ever-increasing interest payments, even if more and more capital moves into short-term debt, it’s not easy for the yields to go down. Moreover, with the current market expecting the Fed to maintain high interest rates for a long time, people are even more inclined to roll their money in short-term debt. As a result, the demand for long-term U.S. bonds decreases, prices fall, and yields rise. What we’re actually witnessing here is the Federal Reserve’s interest rate policy making its mark on long-term rates. You see, the first three reasons all point to a decrease in the demand for long-term government bonds. The fourth reason, however, is that their supply hasn’t diminished despite the decrease in demand. As we’ve just discussed, the U.S. government continues to borrow at an astonishing rate. This trend shows no signs of slowing down. And the rise in interest rates forces them to take on new debt to pay off the old, creating a vicious cycle. So, in essence, these four factors combined have led to a situation where the supply of 10-year bonds exceeds demand. This results in a price drop and a yield increase. Please note, for the sake of clarity, we’ve tried to use simple language in this video. If you wish to delve deeper into the underlying principles, please refer to my past videos. They’re all interconnected and can help you build a relatively complete financial knowledge base. The links to the videos are in the comments section. OK, by now, I believe you’ve come to understand just how complex and fraught with peril the economic situation behind this curve correcting itself is. Now, returning to the initial question of the video, are we finally on the brink of an economic recession? And what does this mean for our investments? I often tell my audience, predicting the macroeconomy is as unreliable as predicting the stock market. It’s simply not dependable. But that doesn’t mean I can’t share my personal opinions, right or wrong. Just remember, I’m just one of countless darts flying towards a target. Whether I hit or miss, it’s all down to luck. And nothing in this video should be taken as investment advice. With the analysis we've just walked through, and considering the historical accuracy of bond yield inversion in predicting recessions, I would say there's a significant likelihood that America is on the cusp of an economic downturn. Of course, the Federal Reserve is aiming for a soft landing, striving to achieve a neutral level of interest rates, while keeping inflation in check, securing jobs, and still hoping for a bit of economic growth. However, if history is any guide, the odds aren’t particularly in their favor. Influencing the economy through monetary policy is hardly a precise science. If the Federal Reserve could guarantee hitting the mark every time, we wouldn’t find ourselves in the predicament we are in today. I believe this is something many of you can appreciate, especially after witnessing the quantitative easing during the pandemic, followed by the era of high inflation and high interest rates. So, whatever the future holds, preparing for the worst is never a bad strategy. Does this mean you should sell all your investments and sit on cash? Certainly not. I personally believe, given the current circumstances, investors need to embrace three key principles: The stock market is not the economy. Interest rates do not solely dictate the stock market’s behavior. People often forget the stock market reflects investor expectations about the future, not a current economic report card. So it’s of paramount importance to maintain a long-term perspective in investing. Meanwhile, you might hear a lot of assertions claiming that high interest rates are here to stay for the long haul. That the stock market won't relive its glory of the past decade or so. These statements about interest rates might be right, but their conclusion could be off the mark. I’ve delved into this topic in a previous video, discussing the relationship between interest rates and stock market returns in detail. They aren't strictly positively correlated. The short-term performance of the stock market depends on numerous factors. In the long run, though, the primary driver is still the economic gains brought about by productivity, not interest rates. Rather than interest rates. History has repeatedly shown that economic downturns often present the best investment opportunities. Going with the flow in investing might look good in the short term, but it might not be beneficial for you in the long run. For instance, the current bear market in both stocks and bonds might deter many from investing, while in comparison, high-return, low-risk cash savings seem like a no-brainer. Holding some cash is never a wrong choice at any given time, but putting all your eggs in cash or going all in during a bull market are both reactions driven by extreme emotions. One springs from fear, the other from greed. But let's circle back for a moment. Even if one wishes to invest during an economic downturn, their circumstances might not always permit it. And this brings me to my third point: Our success or failure, more often than not, depends on our circumstances. And circumstances, we must actively create. Many people often find themselves in the unfortunate situation of "right time, but no money to invest" or "plenty of capital, but no clue what to invest in." They feel like it's just bad luck, and they have no choice. But often, this is a result of going with the flow, neglecting to proactively create an advantageous position for oneself. For instance, when the economy is thriving, you could have chosen to invest conservatively, not chase the highs, and set aside some funds for emergencies, creating your own safety margin. But too many choose to go all in, even taking on crazy amounts of debt, only to find themselves in a bind when the economy takes a downturn. This is neither bad luck nor a lack of choice; it’s a lack of awareness to position oneself advantageously. In the same way, during an economic downturn, we are presented with a choice: to learn from our experiences, to improve our personal finances, to educate ourselves and invest in our own growth, to increase our income and continue investing, positioning ourselves advantageously for the next bull market. That's the critical importance of positioning. OK, that's everything for this video. Creating content like this isn’t easy, so if you found it helpful, I'd welcome you to subscribe, like, and leave a comment. It would mean a lot to me. Until next time, goodbye!
