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Inverted yield curve: How it predicts financial disaster

The inverted yield curve is the bellwether for an economic recession. Here’s how it occurs and what you should know and do about it.

Tony Tran

 

The inverted yield curve is a graph that shows that younger (shorter) treasury bond yields are yielding more interest than older (longer) ones.

And it’s terrifying for financial pundits all over the world. It’s a graph that could mean the difference between a thriving bull market or the downswing of a bear market. AND it’s been known to throw entire economies into a state of abject terror and chaos.

Want to see what it looks like? Okay. Don’t say I didn’t warn you …

pasted image 0 15

While it might not seem like much at first glance, the inverted yield curve is actually the bellwether for an economic recession. You know, that thing that happened in 2008 that was kind of a huge deal?

Luckily, the inverted yield curve is a rare occurrence … BUT it’s useful to know what it means and how to spot one when it happens.

Why? Simple: You don’t want to get swept up in the herd mentality of one, and being able to recognize when it happens is the first step in preventing yourself from making bad decisions based on what everyone else is doing.  

So let’s take a look at the inverted yield curve, how it happens, and what it means for you and your finances.

What is an inverted yield curve?

To understand what an inverted yield curve is, you must first understand one of the most basic financial asset classes out there: Bonds.

A bond is like an IOU given to you by a bank. When you lend the bank money, they’ll give you back that same amount at a later time along with a fixed amount of interest.

For example, if you bought a two-year bond for $100 with a 2% annual return on it, that means you’ll get $104.04 back after two years (this accounts for compounding). 

Yes, that’s a low return rate. However, bonds have a number of benefits that justify the small rate of return:

  • They’re an extremely stable investment. This is especially true when it comes to government bonds. The only way you can lose your money with them is if the government defaulted on its loans — which the U.S. government has never done.

  • They’re guaranteed to have a return. This means that you’ll know exactly how much you’re getting on your ROI when you purchase a bond.

  • Longer investments yield higher returns. The longer you’re willing to wait on your bond typically means that you’re going to have higher return rates. I say typically because there are exceptions to this (Hint: It has to do with what we’re talking about right now).

    And when people refer to inverted yield curves, they’re typically referring to the yields on U.S. Treasury bonds, or bonds guaranteed to investors by the U.S. government.

    BONUS: If you want even more information on investment basics, check out Ramit’s video on the hierarchy of investments. Don’t be thrown off by the potato quality of the video — the advice is timeless.

    A yield curve graph shows the returns of those bonds (i.e., the yield) based on maturity, or how old the bond is.

    A typical one looks like this:

    pasted image 0 16
    Notice how it curves? That’s why it’s called a yield curve. (Source:
    money-zine.com)

    The above is a normal yield curve. It shows that older bonds have higher interest rates and will yield more than younger ones.

    On the other hand, an “inverted” yield curve looks like this:

    pasted image 0 15

    This occurs when the curve inverts or goes the other way. It shows that younger bonds (i.e., bonds that are two years or less) yield more in interest than older ones. This shows the lack of investor confidence in older bonds and is a good indicator that a recession is incoming (more on that soon).

    You can find the daily fund rate straight from the U.S. Department of Treasury itself here and chart it out here (you’ll need Flash).

    But a yield curve doesn’t invert on its own. Let’s take a look at a few elements that are needed for an inverted yield curve to occur.

    How does an inverted yield curve happen?

    Humans are more motivated by a fear of loss than anything else. This is a psychological phenomenon called “loss aversion.” When the possibility of loss comes up, we get scared. We remember the things we’ve lost more acutely than what we’ve gained (just ask any gambler). When we’re scared we tend to make weird decisions like selling off all of our investments due to a dip in the markets or splitting up the group in a haunted house so the murderer can pick you off one by one.

    When it comes to a recession, many investors will start to invest in long-term U.S. Treasury bonds as it approaches — since they know that the interest rates on other assets like stocks will soon drop.

    As more and more people begin to buy long-term bonds, however, the Federal Reserve responds by lowering the yield rates for those securities. And since people aren’t buying a lot of short-term U.S. Treasury bonds, the Fed will make those yields higher to attract investors. To recap:

  • Bonds are considered safe.

  • People who are not confident in the market will move more money into bonds.

  • With more people investing in bonds, their return rate goes down.

    This is basic supply and demand. The less people want a bond, the more financial institutions like the Fed are going to make that bond appealing to investors.

    A great example of a yield curve inverting occurred before the 2008 housing market crisis in December 2005 — almost three years before the crash. The Fed raised the federal fund rate to 4.25% due to a number of factors. Mainly, they were aware that there was a growing price bubble within certain assets like housing, and they were concerned that low interest rates were causing this.

    So when the fund rate was raised to 4.25% in 2005, it caused the two-year U.S. Treasury bond to yield 4.4% while the longer term seven-year bond only yielded 4.39%. Soon the curve began to invert more and more as the recession began approaching and investors continued to invest more heavily into longer-term bonds.    

    Eventually, the United States found itself thrown into a recession after the housing market crash roughly two years later.

    Note: The inverted yield curve wasn’t the cause of the recession but rather a symptom of it. Think of the inverted yield curve as a cough or fever in a greater sickness.

    The last seven recessions the country has seen were preceded by an inverted yield curve — and many experts agree that another inversion of the yield curve could be on its way.

    While the inverted yield curve is a great indication that there’s a recession and a subsequent bear market is on the way, what does that mean for you? What should a typical non–Wall Street, every-person do when you see a headline like this?

     


Posted by Narbik Karamian on December 10th, 2018 9:48 AMLeave a Comment

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Jeff Cox | @JeffCoxCNBCcom

7/26/2017

  • The Fed's balance sheet contains $4.5 trillion of mostly bonds that it accrued as it tried to jump-start the economy after the financial crisis.
  • Fed watchers expect the central bank to indicate that unwinding the balance sheet will start in September.

Consider the Federal Reserve the Starship Enterprise of monetary policy: It went where no central bank had gone before, and now must plot the journey home.

The Fed already has begun one leg of the trip, as it has started raising interest rates from financial crisis-era lows. Now, it is preparing to embark on what could be the more perilous part — shrinking the $4.5 trillion of bonds it holds on its so-called balance sheet.

In an effort to jump-start the economy out of the financial crisis and the Great Recession, the Fed instituted three rounds of bond buying aimed at getting the financial markets going again and generating what officials call a "wealth effect" that would spread through the economy.

While it may sound like just arcane monetary talk, the stakes are high for both investors and consumers.

Get it right and the Fed will have pulled off what its critics thought impossible, namely embarking on unprecedented intervention in the markets with little consequence.

Get it wrong and the fallout could be dramatic, including a sharp rise in interest rates and tumult in the stock and bond markets.

The Fed on Wednesday is expected to provide more clues about when the operation will begin. In the obtuse world of Fed-speak, central bank watchers are looking for whether the official post-meeting statement changes the language from balance-sheet reduction expected before the end of the year to "relatively soon."

How it works


The Fed's balance sheet in total now runs $4.53 trillion, nearly all of which is either Treasurys or mortgage-backed securities. Of the total, $3.7 trillion came during three rounds of buying that began in response to the Great Recession of 2007-09. The program, known as "quantitative easing" or, more colloquially, "money printing," was aimed at injecting money into the economy and encouraging risk-taking following the devastation of the financial crisis.

The Fed bought Treasurys, now totaling $2.46 trillion, and mortgage-backed securities — loans packaged together as bonds now valued at $1.78 trillion — and they will be the focus of the balance-sheet operation.

Those bonds carry various maturity dates. When the bonds reach maturity, current policy entails reinvesting the proceeds. That helps keep demand in the market for government bonds and holds rates low.


USS Starship Enterprise Fed goes where no one has gone before.


Gabe Ginsberg | Getty Images 


Under the current plan, the Fed will set caps on how much of the proceeds will be allowed to run off each month and reinvest the rest. The caps will raise in increments until they reach $50 billion a month, with $30 billion coming from Treasurys and $20 billion in MBS.

How long the process will last is unclear at this point. Goldman Sachs economists said they expect the balance sheet will come down to $2.6 trillion to $3 trillion in a process that likely would run until November 2021.


What could go wrong


Both the stock and bond markets have come to depend on the Fed's programs — both the low interest rates and the balance sheet expansion — in the post-crisis years. Stocks, as measured by the S&P 500, have surged more than 250 percent since the recession lows, while interest rates have remained low across the spectrum.

Any fiddling with a $4.5 trillion batch of bonds, then, could have major consequences if it's not done the right way.

Fed Chair Janet Yellen has insisted the process will have minimal impacts — "like watching paint dry" is her preferred metaphor. So far the market seems to agree, with Goldman projecting that the ultimate impact of the program will add 0.65 percentage points to the 10-year Treasury yield from the beginning until 2021.

But Fed critics have worried for years that the central bank's reluctance to unwind crisis-era policies long after the crisis passed poses substantial dangers. The day is coming, then, when that will be put to the test.

"I have a bridge to sell you if you think a rate hike cycle combined with a shrinking balance sheet will go smoothly," Peter Boockvar, chief market analyst at The Lindsey Group, said back when the Fed first began talking about the balance sheet operation publicly. "If the exit process ends up turning messy — defined as a recession and bear market in stocks — was all this easing worth it? Be bullish if you think both news stories will turn out just fine. Be very worried if they don't."


What else is at stake?


Either way the Fed works things, the process of shedding trillions of dollars in bonds will take a long time.

Greg McBride, chief financial analyst at Bankrate.com, sees the process ultimately lasting 15 or 20 years, with plenty of rests in between as the Fed goes back to asset purchases during economic downturns.

"When you look at the context of a slow-growth economy, productivity growth that is abysmally low — that all adds up to a Fed that's not going to be able to be aggressive with interest rates or downsizing the balance sheet," McBride said in an interview earlier in the year.

"Seeing slow progress on both of these fronts just brings us to the intersection of an inevitable economic slowdown at some point long before interest rates get to more normal levels and the balance sheet is reduced significantly in size," he added.

However, there's a rather significant intangible in play.

Yellen may be winding down her career, with many Fed watchers figuring that President Donald Trump will not reappoint her when her term expires early next year. That means the chair may focus at least in part on legacy-building in the coming months.

"Unless renominated, Chair Yellen will leave her seat in February 2018 having defined her legacy as the first central bank leader to have successfully lifted off of the zero lower-bound and to have begun the process of post-financial crisis normalization," economists at Morgan Stanley said in a note. "If all goes well, it will be a gift to her successor.



Posted by Narbik Karamian on July 26th, 2017 10:14 AMLeave a Comment

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by: Jann Swanson

Foreign Homebuyers Surge into U.S. Market

 

Jul 18 2017, 11:09AM

Our neighbors to the north seem to think the grass is pretty green on this side of the fence.  The National Association of Realtors® (NAR) says that foreign investment in the U.S. residential market skyrocketed to a new high during the 12 months that ended in March. Those sales were fueled by a substantial increase from Canadian buyers. 

NAR released results from its 2017 survey of international residential buyers on Tuesday. It shows buyers from each of the top five home countries increased their activity from 2016, and that nearly half of all foreign sales were in Florida, California and Texas.

Between April 2016 and March 2017, foreign buyers and recent immigrants purchased $153.0 billion of residential property.  This is 49 percent more than was indicated in the 2016 survey ($102.6 billion) and surpasses 2015's total of $103.9 billion, setting a new survey high. There were 284,455 U.S. properties purchased by foreign buyers, a 32 percent increase, accounting for 10 percent of the dollar volume of existing-home sales compared to 7 percent in 2016.

NAR's chief economist Lawrence Yun said, "The political and economic uncertainty both here and abroad did not deter foreigners from exponentially ramping up their purchases of U.S. property over the past year.  While the strengthening of the U.S. dollar in relation to other currencies and steadfast home-price growth made buying a home more expensive in many areas, foreigners increasingly acted on their beliefs that the U.S. is a safe and secure place to live, work and invest."

China held on to the top spot in terms of the dollars spent for the fourth straight year, spending $31.7 billion compared to $27.3 billion in the previous period and replacing the $28.6 billion spent in 2015 as the new survey high.  For the third straight year they also purchased the most housing units, 40,572, up from 29,195 in 2016.

However, it was the massive hike in activity by buyers from Canada that stands out. Their purchasing had dipped from $11.2 billion in 2015 to $8.9 billion last year, but soared to $19.0 billion in the latest survey - a new high for that country's buyers.  

Yun says this increase is because Canadians are buying property in expensive U.S. markets that are still more affordable than what they can buy at home. While much of the U.S. is seeing fast price growth, the gains in many cities in Canada have been steeper, especially in Vancouver and Toronto.  

"Inventory shortages continue to drive up U.S. home values, but prices in five countries, including Canada, experienced even quicker appreciation," Yun said. "Some of the acceleration in foreign purchases over the past year appears to come from the combination of more affordable property choices in the U.S. and foreigners deciding to buy now knowing that any further weakening of their local currency against the dollar will make buying more expensive in the future."

The third greatest amount of spending was on the part of buyers from the United Kingdom, $9.5 billion, followed by those from Mexico, at $9.3 billion, and India, $7.8 billion. All three groups also increased their purchasing compared to 2016.

Foreign buyers paid a median of $302,290 for their American homes, a 9.0 percent increase from the median of $277,380 in the 2016 survey and substantially higher than the $235,792 median price for all existing homes sold during the same period.  Approximately10 percent homes sold to foreign buyers were priced over $1 million, and 44 percent of transactions were all-cash purchases.


Posted by Narbik Karamian on July 18th, 2017 9:17 AMLeave a Comment

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