What is the Yield Curve, and Why is it Flattening?

you may have heard rumors that analysts are expecting a recession in the next few years while reasons range from high debt levels to aggressive fiscal policy there's one signal coming li referenced that's a little tricky to understand the yield curve while this indicator may look simple enough there's a lot to interpret from it and for many they don't like what they see interested we'll dive into the topic and more on today's plain bagel if you follow the markets you've probably heard analysts referencing something called the yield curve when discussing the economy maybe even had a chance to see the elusive curve itself or perhaps you know any what I'm talking about regardless the yield curve has been under the spotlight recently so it's probably worth taking the time to understand after all if you're to believe it following the yield curve may help you predict the future sort of you see it's widely believed that the yield curve is a leading indicator and that certain movements in shape are signals of bad news to come but before we get into the advanced stuff let's break down what the yield curve actually is when we talk about yields and investments we referring to how much an investor is being paid from their investments as a percentage of the holdings value with stocks we'd have your dividend yield which is your dividend paid divided by the songs price but for the yield curve we're actually referencing bond yields so the interest or coupon payment of a bond as a percentage of its price if a bond pays a coupon of $60 a year it's trading at $1,000 its yield is 6% the yield basically tells you how much money your money is generating but because it's based on an investments price it changes with the value of the bond if the bond goes down to a price of 950 dollars then the yield goes up to six point three percent obviously this doesn't mean much if you hold your bond to maturity but if you sell your bond this will make it more attractive to other investors ignoring everything else after all they're receiving the same dollar payments as you were a pain $50 less to receive them alternatively if your bond goes up in price then it will become less attractive an important point that we'll touch on again later but that's the yield part the curve part comes in when we take a series of bonds and graph their yields so let's draw our two axes and put yields on the y-axis on the x-axis will put our bond maturities which refers to how long the bond in question is outstanding bonds are dead after all and like most debts they need to be paid back at some point as for which bonds we take the data from we can use any series to create a yield curve but if we want to get the yield curve the one all the journalists are talking about well then we've got to use US Treasury bonds which are bonds issued by the US government so if we take Treasury bonds from a variety of maturities and plot their yields we end up with a curve now the shape of the yield curve is very important you'll notice that upward sloping meaning that longer term bonds pay investors higher interest rates there's a number of theories as to why but I'm only gonna highlight one well the quiddity premium query the idea here is that longer-term bonds pose a higher risk to investors than shorter term bonds as they type your money for a longer period of time over which a negative event may impact the value of your bond or a more attractive investment may arrive for example let's say you have two investors one who buys a two-year government bond and one who buys a 10-year government bond and let's say that after a year and a half the government starts issuing a higher interest rate bonds while this would hurt the value of both outstanding bonds since they are now less attractive be invested with the 2-year bond wouldn't be too concerned even though the market value of their bond has fallen they'll get back the full par value of the bond the amount borrowed by the government in six months when it matures whereas the ten-year bond investor will have to wait longer even though there's now a more attractive investment option while the two-year bond holder can move into the more attractive investment earlier the ten-year bond holder will have to either sell their bond at a discounted price or wait eight and a half years accepting the lower return all the wild so longer-term bonds offer less optionality to investors and as a result they tend to pay investors a liquidity premium coupon rate to compensate them for the added risk this is what causes the upward sloping yield curve which is known as a normal curve so all in all the yield curve is pretty straight forward it simply visualizes the difference in interest rates between different bond maturities in fact it's so simple that some people don't even use the whole thing producing instead to a single number known as the yield spread which is the difference between the ten-year Bend the two year Treasury bond yields so the graph is so basic why do people care so much about it here's where it gets interesting the old curve doesn't always look normal sometimes it changes shape for example the curve from time to time has been known to flatten and when that happens investors tend to beliebe recessions on their to understand why we first need to understand how naturally a flat yield curve can be caused by either the short-term yields of increasing or the long term yields falling the Federal Reserve has a lot of influence on the left side of the curve but the right side is harder to control after all if the Fed increases the coupon rates of the bonds it will take a long time for a small outstanding long-term bonds to mature and for the new rate to reflect in the yield curve but there is something that can cause the right side to move very quickly remember there are two parts of the yield equation the bonds coupon payment which is based on the feds interest rate and the bonds price and if people start demanding more long-term bonds it will cause prices to increase so if we see more people buying on the right side of the curve it will weigh down long-term bond yields causing the yield curve to fly now here's why this is a bad thing with a flat yield curve investors have bought long-term bonds to the point where the build is no more attractive than that of short term bonds in other words investors believe that there is some greater risk out there that outweighs the risk of longer-term bonds this could be because they expect future interest rates to fall and are rushing to secure current rates or because they expect other investments to perform poorly both of these come from expectations that the economy is going to slow down whether it be because of slowing consumer demand rising debt levels or some other economic data point regardless of the reason investors are rushing into long-term government bonds and if the situation doesn't improve it could actually push the yield curve into an inverse position where concern over the economy is so great investors are accepting lower returns just to ensure that they have a long term source of interest but that's a lot of theory to extrapolate from a simple dumb graph and just because investors are worried about the economy doesn't mean we're about to enter a recession right well here's the crazy thing history seems to back up the predictive power of the yield curve if we look at the yield curve for the three years leading up to the 2008 financial crisis well we can see a pretty clear trend in the shape of the curve same thing goes for the 2000 tech bubble while it's a little more gradual come 2000 we're seeing three-month bonds offering the same yield as 30-year bonds part of the reason for this is that the flat yield curve is somewhat self-fulfilling as a negative in Decatur as the curve flattens it hurts the profitability of financial institutions and can make access to capital difficult for corporations so the reason why people watch the curve so closely is that it essentially gauges investor expectations and if history is to repeat itself we can predict an impending recession which leaves us to the obvious question what does the curve look like today well there's no need to panic here's a curve as of July and as you can see it still looks normal but with policy rates on the rise it has been flattened E which naturally has people a little concerned so are we entering a recession should we sell everything and board up the windows well probably not the old curve is far from exact science and the flat curve could come three months or three years before a recession not to mention we can easily see it expanding and moving forward even the implications of flat and inverted yield curves are up for debate that's the thing about economics it's ever-changing and full of different schools of thought not to mention that what has happened in the past probably won't recur perfectly in the future so while we can hedge our risk trying to pinpoint the next recession and timing the markets is often a bad call what should you do with this information if not try to avoid a recession well the best approach is to make sure your bases are covered it's possible that a recession is on the horizon so diversify your holdings set up an emergency fund and make sure your investment risk exposure matches your tolerance aside from that there's not much else you need to do if you're investing for the long term after all if you hold a portfolio of high-quality stocks you don't need to worry about the short-term implications of a recession so the yield curve is a pretty cool tool and tells us a lot about the current state of the economy but watching every day probably won't put you any further ahead of other investors after all making money we're as simple as watching a single indicator well my job would be a lot easier but with that said we're out of time if you like this video please hit the like button and you feel like what we're doing here please subscribe hit the ballet icon to make sure you get notifications about future videos if you have any feedback or topics you'd like us to cover in future videos leave a comment down below for the play Magel my name is Richard coffin thanks for joining me today [Music] you

Channel: The Plain Bagel

Views: 543,197

Keywords: Yield Curve, The Plain Bagel

Id: 5L_zQGPNXOk

Length: 8min 59sec (539 seconds)

Published: Fri Aug 03 2018