QUOTE OF THE WEEK
“When you practice gratefulness, there is a sense of respect toward others” – Dalai Lama
TECH CORNER
Let’s talk about the Yield Curve today and how it affects the economy.
First what is the Yield Curve? There are multiple Yield Curve examples but today we will talk about the most common, the yield of the 10yr US Treasury vs the yield of the 2yr US Treasury.
The math of the Yield Curve goes as follows: Take the yield of the 10yr and subtract the yield of the 2yr. The current 10yr yield is 4.21% and the yield of the 2yr is 4.95%. This computes to a negative yield of -0.74% thus an inverted yield curve.
Now assume you are a bank and you are deciding whether to make a loan using only the interest rate example of the Treasury yields. Under normal conditions we have a positive Yield Curve meaning you take in deposits at say a normal 1% and you loan them out at 4%. Your profit is the difference of 3%. By the way, most long-term loans including mortgages, are tied to the 10yr rate.
Now what we have is a situation where the Fed is raising the Federal Funds rate to control inflation. That rate controls the short end of the interest rate curve (2yr rate). So, in the example above with short term interest rates at 4.95%, you would have to pay sophisticated investors at that rate to attract deposits. Loaning that money out at the long term rate of 4.21%, it would be unprofitable to make the loan.
In the old days most depositors were happy to get the low interest rate on their deposits. Now, sophisticated depositors aren’t satisfied being paid a low interest rate and are moving their deposits out of the bank and into short term rates via a Government Money Market Fund or buying 2yr Treasuries.
Keep in mind that loans are the oil of the economy. So, in this case, you as the bank are seeing your depositors taking their money out to get a higher rate. What this means for the economy is that, again, you as the bank, are not going to make an unprofitable loan nor do you have the money in deposits to loan because your depositors are fleeing to get higher interest rates. The effect is that loan volume dries up and if loans aren’t being made, the economy slows down.
The graph below shows what happens when we get an inverted Yield Curve as we have now, a recession (shown in grey) follows. This current yield curve is the most inverted going back to 1985. The probability of a recession following a period of an inverted yield curve has been 100%. The prediction of the political pundits and the news media is that we won’t have a recession or we will have a soft landing which may be highly improbable. Although I can’t say that won’t happen, we believe in data which is why we are positioned in bonds.
