Claire Corlett

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Fisher Investments on Yield Curves | Capital Market Update [2019]

Fisher Investments on Yield Curves | Capital Market Update [2019]


There’s been a lot of talk lately about yield
curves. How do yield curves impact markets? Probably one of the most fundamentally misunderstood
and yapped about topics that we see, especially in a time like this, and it’s misconstrued
in a variety of ways. And so, cutting through all the chaff, what
really matters with the yield curve is that the yield curve is a signal, it’s not a thing
in itself. What you’re trying to determine is, what are
the economic conditions for loans to be making or banks to be making credit and loan activity? Bottom line and so, what a yield curve is
effectively is, short term interest rate where a bank borrows from the saver or the depositor
at a very short term interest rate and then they lend that same money out, corporations,
auto loans, corporate loans, whatever it is. The difference between those two is the profit
for the bank, what they borrow at, what they lend at. So when a yield curve is steep, it means the
bank’s potential profits are high because if they make those loans, they can profit
a lot. It’s call the net interest margin. As the yield curve gets less steep and it
starts to flatten, it means the bank’s potential for profit starts to lessen because the spread
on what they can make is less. And so the narrowing of the yield curve is
a signal and it tells you maybe you don’t wanna be as optimistic about banks and financials
as you were before. Typically, it’s towards the middle of the
cycle, the financials tend to do better and towards the end of the cycle, they tend to
do worse. And it’s a key reason why overall we’re underweight
financials, both in the US and Europe although we do hold quite a few of those European banks. But in terms of the yield curve as a signal
for a bear market, this is where things get very strange. A lot of people will take things like the
two year minus the five year or the five year minus the two year and the 10 year minus the
five year or whatever it is, and all these other metrics. The most durable that we’ve ever seen is really
just taking the three months short term rate and the 10 year Treasury bond and comparing
those. And today, it’s flatter than it was but it’s
still positive. And even tiny positive is still fine for the
stock market and fine for the cycle. When yield curves truly invert, when long
term interest rates go below the short term interest rate, it has to do so for a meaningful
amount of time and it has to be widespread because another widely misconstrued feature
is that people just tend to look at their own country and say, that yield curve is flat
or negative and therefore, we’re going to have a recession. But the truth is, it’s a global world. And one of the things that we look at is,
a globally weighted, or GDP weighted yield curve which is still very nicely positive. Because even if there’s weakness in one area,
it’s gonna be tended to be picked up by other areas that still have nicely positive yield
curves. And one of the things we mentioned earlier,
was that in fact Europe has a nicely steep yield curve, at least relative to other places. But very importantly in terms of the bear
market and the signal, one of the things that we see the most often is that people get too
frightened as the phenomenon of yield curve flattening is happening. When in fact as it’s flattening, is some of
the best times of a bull market, very frequently. And it’s not until you either get a true inversion
that lasts a while and is widespread that you can really get something that’s truly
a recession indicator. But if you don’t wait for that, you’re gonna
get out way too early and miss out on a lot of the gains of a bull market. And two amplification points here. One of the reasons that the global is more
important than the single country’s is because in today’s world, global banks can borrow
in one country and lend in another. They can take advantage of those inter-country
spreads. The second point and Michael said this correctly
but you can amplify on the point that, looking at something like the two or the three year
versus the five or 10 year, is inappropriate because the core principle you’re trying to
look at is the underlying function of the banks taking in short term deposits as the
basis for making longer term loans. And banks don’t take in much in the two or
three year time range as deposits. What they take in as deposits tend to be very
short term. You could use as Michael says, the 90 date
rate. Or you could actually use the overnight rate,
and either one are gonna show you pretty much the same thing. Because it’s the short term stuff, that’s
where banks do the borrowing. They take in the deposits against which they
then make long term loans. But there has been this tendency in 2018 as
people were looking for bad and looking for problems, and fomenting and worrying to look
for the part that’s the part that’s the part that looks the worst which was the two or
the three against the five or the 10. And in fact if they could, they’d look at
the 2.3789 versus the 8.235 if that showed them the worst thing. It’s really you want short, short, versus
long, long. ‘Cause that’s really the signal. And all that really matters is the propensity
of the banks to want to lend. Because in the end, what this is really about
is can business and consumers that are adequately qualified to borrow otherwise for basic fundamental
purposes get access to credit. Can they actually borrow? And when you take basic economics in school,
one of the most principle basic functions that you’re suppose to learn that just kind
of goes (whooshing) to a lot of people, is that in a fractional reserve banking system
like we have throughout the western world, the quantity of money grows by the banking
system increasing its net outstanding loans. And that process of bank’s propensity to lend,
is basic and fundamental. And that’s what the yield curve is giving
you an indication of. But the indication itself is not the be all
and end all. It’s that lending that’s the be all and end
all which has actually gone along reasonably well. And for views on current events in the world
of investing, visit marketminder.com. Updated daily, it offers on-demand access
to Fisher Investments’ most current thoughts on capital markets and the global economy,
as well as our sometimes irreverent commentary. We hope you’ll enjoy it!

3 comments on “Fisher Investments on Yield Curves | Capital Market Update [2019]

  1. The 5 year rate is relevant for auto loans or household items loans. Still relevant. Could spark decline of auto sales and snowball from there.

  2. Interesting that Buffet went recently long financials citing reasonable valuations. Perhaps we are mid cycle and not end of cycle ? Wow, all comments by an 'Alex'. This is miraculous)

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