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Yield Curve Inverts
Old 12-03-2018, 06:54 PM   #1
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Yield Curve Inverts

Kevin Drum:
"Generally speaking, the yield on a 5-year treasury bond should be higher than it is on 3-year bond. After all, the longer term means you’re taking on a little more risk. Today, however, after years of breathless waiting, this is no longer true. The yield curve has “inverted,” and as I type this both 3- and 5-year bonds are yielding 2.84 percent.

"The conventional wisdom says that this is because investors are betting on the Fed reducing interest rates in the near future. With lower rates around the corner, investors want to lock in the higher rates currently available for as long as they can, so they’re snapping up 5-year treasurys, which in turn has reduced their yield below the 3-year rate.

"That all makes sense, but why do investors think the Fed will shortly be reducing interesting rates? Because a recession is coming.

"That’s the conventional wisdom, anyway. You may decide for yourself whether to believe it."

https://www.motherjones.com/kevin-dr...-has-inverted/
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Old 12-03-2018, 07:01 PM   #2
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With yield curve slope they are generally looking at the 10 year versus the 2 year. Although the yields are very close, that part of the curve has not yet inverted. With yields super close it makes more sense to describe it as flat anyway.
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Old 12-03-2018, 07:14 PM   #3
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Originally Posted by audreyh1 View Post
With yield curve slope they are generally looking at the 10 year versus the 2 year. Although the yields are very close, the curve has not yet inverted. With yields super close it makes more sense to describe it as flat anyway.
There are spreads (2-10) and spreads (2-5). Market chatter is that the 2-10 may not be as useful an indicator as it was in the past because with the reversal of QE there is more pressure on the long end of the curve that has nothing to do with market sentiment about the future as expressed via the yield curve. As such, we may get better information looking at the shorter maturity curve.

All that said, an inversion anywhere on the curve doesn't necessarily mean anything. I will say that I am more comfortable moving a little farther out on the yield curve given recent pronouncements.
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Old 12-03-2018, 08:07 PM   #4
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That article is garbage. We must look at what is the yield curve and what it truly means.


Yield curves are critical indicators of credit market health. For that reason, yield curves are a very important leading economic indicator.

The yield curve is an issue because banks borrow at short rates ( fed funds) and lend at longer rates ( 10 year)
If it is sloping upwards that is a positive because banks are lending which leads to helping the economy chug along. When short rates are higher than the long rate it chokes off lending and hurts profitability along with providing fuel to businesses. It's really pretty simple.

The current fed funds rate is 2.25% and the 10 year is just over 3%. That is a nice , healthy cushion and although it has flattened at different times in this cycle it does not always lead to inversion.
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Old 12-03-2018, 08:36 PM   #5
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Originally Posted by FREE866 View Post
That article is garbage. We must look at what is the yield curve and what it truly means.


Yield curves are critical indicators of credit market health. For that reason, yield curves are a very important leading economic indicator.

The yield curve is an issue because banks borrow at short rates ( fed funds) and lend at longer rates ( 10 year)
If it is sloping upwards that is a positive because banks are lending which leads to helping the economy chug along. When short rates are higher than the long rate it chokes off lending and hurts profitability along with providing fuel to businesses. It's really pretty simple.

The current fed funds rate is 2.25% and the 10 year is just over 3%. That is a nice , healthy cushion and although it has flattened at different times in this cycle it does not always lead to inversion.
I think you managed to get all of your points exactly wrong. If I could figure out how to give you a gold star, I would. In any case, here is a bacon flag:
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Old 12-03-2018, 08:41 PM   #6
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I think you managed to get all of your points exactly wrong. If I could figure out how to give you a gold star, I would. In any case, here is a bacon flag:
Tell me what I said is wrong
thanks
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Old 12-03-2018, 08:55 PM   #7
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Tell me what I said is wrong
thanks
OK. Please take this in the spirit of education, not me trying to "told you so." It is sincerely intended solely as an explanation as requested.

The yield curve we are discussing is specifically for US govt rates. In theory there is a smidge of credit risk in these rates, but as a matter of practice market participants generally refer to treasury rates as risk free rates. The ability to run the printing press at will to pay debt denominated in your own currency essentially does away with any normal definition of credit risk. So the level, trend or shape of the curve of treasury rates does not in itself say anything about credit risk or credit markets.

As for the bank lending issue, things are a little more complicated than that. Banks borrow overnight, for 3 months, for a year, for 5 years, for 10 years... You get the idea. They lend to borrowers for a certain term, but the rate on the loan may or may not be fixed for the life of the loan. Most banks would be delighted to have their liabilities be 3 month duration and be able to make loans that have rates that reset every 3 months. Voila! They take no interest rate risk to speak of. The yield curve impacts banks to the extent that they do not have assets and liabilities closely matched, but it is rare to find a bank that borrows short and lends at long (10 years is a loooonnnnggg time for these guys) in any size or volume unless they use derivatives to hedge the exposure. Banks that do so generally do not survive over interest rate cycles (see: Hudson City Bank). Mostly, banks care more about the spread they earn lending money to credit risky customers than they do about the yield curve.

You also compared the fed funds rate and the 10 year. Most market participants do not watch this spread. Instead, they watch the 2 year too 10 year spread. That closed at under 20 basis points today, a very, very skinny level that has in the past signaled a possible recession. I would point out that it has predicted 8 out of the last 5 recessions, but it isn't a signal to be ignored.
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Old 12-03-2018, 09:00 PM   #8
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Help me find the current inversion:

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Old 12-03-2018, 09:01 PM   #9
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Isn't there generally a lag of 12-18 months between a yield curve inversion and the start of a recession (if there is to be one at all)?

Edit to add - corn18 beat me to the punch and has answered my question with his chart. Thanks.
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Old 12-03-2018, 09:02 PM   #10
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Isn't there generally a lag of 12-18 months between a yield curve inversion and the start of a recession (if there is to be one at all)?
I believe it historically has been like 18 to 24 months. Often there is an equity market peak between the inversion and the recession as well.
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Old 12-03-2018, 09:03 PM   #11
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Help me find the current inversion:

That is the 10 year minus 2 year which has not inverted yet.
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Old 12-03-2018, 09:04 PM   #12
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Originally Posted by corn18 View Post
Help me find the current inversion:

In the 2-10 spread there isn't one. The spread has gotten really skinny, but it is above the waterline. The inversion that happened today was between the 2 or 3 year treasury and the 5 year.
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Old 12-03-2018, 09:09 PM   #13
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OK. Please take this in the spirit of education, not me trying to "told you so." It is sincerely intended solely as an explanation as requested.

The yield curve we are discussing is specifically for US govt rates. In theory there is a smidge of credit risk in these rates, but as a matter of practice market participants generally refer to treasury rates as risk free rates. The ability to run the printing press at will to pay debt denominated in your own currency essentially does away with any normal definition of credit risk. So the level, trend or shape of the curve of treasury rates does not in itself say anything about credit risk or credit markets.

As for the bank lending issue, things are a little more complicated than that. Banks borrow overnight, for 3 months, for a year, for 5 years, for 10 years... You get the idea. They lend to borrowers for a certain term, but the rate on the loan may or may not be fixed for the life of the loan. Most banks would be delighted to have their liabilities be 3 month duration and be able to make loans that have rates that reset every 3 months. Voila! They take no interest rate risk to speak of. The yield curve impacts banks to the extent that they do not have assets and liabilities closely matched, but it is rare to find a bank that borrows short and lends at long (10 years is a loooonnnnggg time for these guys) in any size or volume unless they use derivatives to hedge the exposure. Banks that do so generally do not survive over interest rate cycles (see: Hudson City Bank). Mostly, banks care more about the spread they earn lending money to credit risky customers than they do about the yield curve.

You also compared the fed funds rate and the 10 year. Most market participants do not watch this spread. Instead, they watch the 2 year too 10 year spread. That closed at under 20 basis points today, a very, very skinny level that has in the past signaled a possible recession. I would point out that it has predicted 8 out of the last 5 recessions, but it isn't a signal to be ignored.
OK, no offense, but you started with a snarky "you missed on every single point" and then came back with a post that showed your ignorance of how banks work.

The fed funds is the one that matters NOT the 2 year---banks borrow at that rate (fed funds)--thats the important one. You are overcomplicating the issue. It's a very simple concept. Banks’ business model relies on borrowing short term (think: depositors) and lending long (think: businesses and homeowners). Thus, a steeper yield curve means more profitable lending and vice versa.
you said "10 years is a lonng time for banks to lend at"?? haha really? you think most business loans are for less than that? and peoples mortgages are less than 10 years?

the media frequently talks about "yield curve" because its a catchy theme these days without even considering what it really means. Again, as I stated--Yield curves are critical indicators of credit market health. For that reason, yield curves are a very important leading economic indicator. But they don't borrow at 2 year rates! An inverted yield curve—when short rates exceed long—suggests banks will struggle to lend profitably. This is a signal credit markets aren’t functioning well—potentially impacting economic growth.

"in the spirit of education "
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Old 12-03-2018, 09:12 PM   #14
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Old 12-03-2018, 09:25 PM   #15
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In the 2-10 spread there isn't one. The spread has gotten really skinny, but it is above the waterline. The inversion that happened today was between the 2 or 3 year treasury and the 5 year.
Seriously? It's like .01 inverted. Cats and dogs living together.
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Old 12-03-2018, 09:30 PM   #16
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Seriously? It's like .01 inverted. Cats and dogs living together.
Some market observers use 50BP spread or less on the 2-10. We have been there for a while.

Personally, I think the signals we are getting from the yield curve are likely to be less useful predictors than has been the case in the past because of the effects of QE and its reversal. Still interesting to watch. Wish I could do so from a safe distance.
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Old 12-03-2018, 09:34 PM   #17
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Let's see if the 2-10 inverts.

As far as the article, I tend to not get my financial news and perspective from Mother Jones.

For some reason.
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Old 12-03-2018, 09:35 PM   #18
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Some market observers use 50BP spread or less on the 2-10. We have been there for a while.

Personally, I think the signals we are getting from the yield curve are likely to be less useful predictors than has been the case in the past because of the effects of QE and its reversal. Still interesting to watch. Wish I could do so from a safe distance.
Shouldn’t the QE reversal be pushing up the long rates? Or has that already been happening and long rates are having trouble getting/staying higher in spite of QE unwind?
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Old 12-03-2018, 09:51 PM   #19
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OK, no offense, but you started with a snarky "you missed on every single point" and then came back with a post that showed your ignorance of how banks work.

The fed funds is the one that matters NOT the 2 year---banks borrow at that rate (fed funds)--thats the important one. You are overcomplicating the issue. It's a very simple concept. Banks’ business model relies on borrowing short term (think: depositors) and lending long (think: businesses and homeowners). Thus, a steeper yield curve means more profitable lending and vice versa.
you said "10 years is a lonng time for banks to lend at"?? haha really? you think most business loans are for less than that? and peoples mortgages are less than 10 years?

the media frequently talks about "yield curve" because its a catchy theme these days without even considering what it really means. Again, as I stated--Yield curves are critical indicators of credit market health. For that reason, yield curves are a very important leading economic indicator. But they don't borrow at 2 year rates! An inverted yield curve—when short rates exceed long—suggests banks will struggle to lend profitably. This is a signal credit markets aren’t functioning well—potentially impacting economic growth.

"in the spirit of education "
Yep, I was snarky. Hard not to be sometimes.

Most banks are heavily reliant on deposit funding, not borrowing in the fed funds market. Deposit funding is typically a lot cheaper and more stable. Most depositors want to stay short and want relatively easy access to their funds. What is the effective duration of such funds? Always subject to the facts and circumstances. I have seen as short as months and as long as 7 or 8 years. The rates on these accounts also tend not too move in lockstep with changes in the fed funds rate.

Banks to some extent borrow short and lend long, but they are highly constrained in how much they can safely do so by both market realities and their regulators. Guess how much banks hold in the way of 15 and 30 year fixed mortgages? Bupkis. Otherwise they die (see: Hudson City Bank). As I said before, banks don't really care about borrowing short and lending long. They care about the credit spread they earn (what they can charge for a loan less what they pay for their funding).

For the record, most business loans are pretty short. Annually renewable (i.e. due in 1 year from origination) is quite common. Term loans with good collateral and covenants might be 5 to 7 years, but those are almost never fixed rate. Commercial real estate on some properties will go fairly long, but the banks routinely swap the fixed rate on the loan to floating via a derivative transaction.

Treasury yield curves do not tell us about credit risk. They tell us about market participants' expectations about future rates and future inflation. Nowadays those signals are distorted by the effects of QE and its unwind, so I think it is worth remembering that the present does not look precisely like the past. That said, look at the history of past inversions and decide for yourself how important it is to pay attention to this signal. After all, what is important is not whether you win an argument with a stranger on the interwebs, but rather that you understand what risks you are taking, accept the ones you want, and get sufficient compensation for those risks.
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Old 12-03-2018, 09:54 PM   #20
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Shouldn’t the QE reversal be pushing up the long rates? Or has that already been happening and long rates are having trouble getting/staying higher in spite of QE unwind?
From what I have read, the gradual unwind is serving to push up 10+ year rates relative to what they would have been otherwise. That means that maybe we would have been 2-10 inverted by now if that were not going on. Or perhaps that is not the case and we are getting a true reading from the yield curve as it exists today. An exercise for the reader...
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