I. what are bonds?
II. what causes interest rates to go up and down?
III. what is a yield curve?
IV. what is an inverted yield curve?
V. why i don't think there will be a recession
VI. what i think of the huawei issue?
-------------------------------------------------------
I. what are bonds?
when you buy a bond, you are basically lending money to the seller (borrower). the price of the bond is the principal. the yield of the bond is the interest that you earn. the yield for the bond you bought NEVER CHANGES until maturity. when the bond matures, you get the entire principal back from the seller, no more, no less. as long as you wait until the bond matures, and as long as the seller (borrower) does not default (go out of business), YOU NEVER LOSE MONEY. your total income is the total interest paid (total yield). keep this in mind because this is the source of confusion for beginners.
short term bonds have a maturity period of 1 to 3 years. medium term bonds are 4-10 years and long term bonds have a maturity period of 11-30 years. you don't need to wait for the bond to mature to liquidate your investment. you can sell the bond to another person even before it matures. if interest rates go down, NEW bond offerings will have a lower interest rate than the bond you own. so everyone would be more interested at your bond compared to the new bond offerings. so the price of your bond goes up, but of course just enough so the buyer will have the same yield as the lower yielding new bonds. that means if you sell it you make more money on top of of the interest income you've earned so far.
example, if you bought your bond for $100 and the interest on the bond is 7%, you earn $7 a year. if the interest rate on similar bonds goes down to 5%, then buyers of new bonds would only earn $5 a year per $100. if there is 10 years left before maturity, your bond will earn $20 more compared to the market (($7 - $5) X 10). so you can sell your $100 bond for $120 to james bond. the reverse happens if interest rates go up.
II. what causes interest rates to go up and down?
if interest rates are too high, there would be less borrowing which means there will be less economic growth and fewer jobs available. but if interest rates are too low for too long, people might borrow too much to the point that they can't repay their loans. oversupply of money can also decrease the value of money (law of supply and demand), thus lowering the purchasing power of people. this is called inflation. high inflation and low interest rates will discourage people from saving and putting their money in the bank. the banks can go out of business and the economy will crash. less jobs and less purchasing power of money equals increase in poverty. if the country is rich enough (e.g. sells lots of products and natural resources to other countries) and the government's outstanding debt is not that high relative to GDP, then the government can bail out the banks and key industries by racking up more debt so the economy can recover. but if this keeps happening a time will come when the country's debt will be too big and it's tax revenues will not be enough to pay even the interest on it's debt. the country can plunge into permanent poverty.
the job of the federal reserve bank (fed) is to control interest rates to control inflation. they usually meet 8 times a year to figure out the best interest rate level (fed rate) to keep the economic growth and inflation at a healthy pace. all major banks are required to keep 10% of it's deposits in the federal reserve to ensure it always has enough money to give to it's customers who are withdrawing money. if a bank falls short of this requirement, they can borrow money from the fed or other banks. the interest rate used when the banks borrow from each other is the fed rate. all other types of loans are based on this rate. example, the base interest rate (prime rate) banks use for home loans is usually 3% above the fed rate. right now the fed rate is 2.5% so the prime rate is 5.5% (it can be more if you have bad credit score). banks earn money on the difference between the fed rate and prime rate.
a good or healthy inflation is around 2%. a modest inflation causes an increase in investment and property values which encourages further investments, business expansion and job creation. over time, inflation will also lessen the true value of the government debt, giving the government a bigger cushion to absorb an economic collapse or recession. example, before WW2, US debt was $40 billion or 43% of GDP. after the war, it was $242 billion or 113% of GDP. imagine if the US never took on any more debt after that and just paid interest. today our GDP is $20 trillion because of the economic growth. the government collects about $4 trillion in taxes annually. that means the $242 billion debt is now just a drop in the bucket - 1.2% of GDP and can easily be paid off with the tax revenues. unfortunately, the US government has been spending more than it collects in taxes so the debt is still around 100% of GDP at around $20 trillion. the debt actually shrunk a little from $242 billion to $20 trillion. sounds stupid? actually it's true because it shrunk from 113% of GDP to 100% of GDP. the US government paid $389 billion last year to service that debt. that's a lot of money considering people are horrified at the $700 billion military budget. we only need $160 billion to give a bronze plan health insurance to the 27 million americans who currently can't afford health insurance and don't quality for subsidies.
III. what is a yield curve?
just like the prime rate, interest rates on bonds (notes) are based on the fed rate. normally longer term bonds have higher interest rates or yield. that's because over a longer period of time there is a greater chance the interest rates will rise, which as i pointed out earlier, will decrease the value of the bond. as i said, the fed needs to raise rates during good times to control inflation. and if you look at the chart of the s&p500 since 1923, there have been much more good times than bad times. also with longer term bonds, the money of the buyers (lenders) is tied up longer (opportunity cost) so they need to be compensated for that too. even if the fed don't raise rates and you hold the bond until maturity, inflation can negate some of the interest earnings and lowers the true value of the principal, so the owner also needs to be compensated with a higher interest. and lastly, the risk of a default is greater the longer the time period. example the risk of me getting into an accident within the next 30 years is much greater compared to the next 3 months.
the yield curve is the graph of the yields (interest rate) of bonds with different maturities. during normal times or healthy economic growth, the yield curve is going up because as i just explained, the longer term bonds have higher rates.
IV. what is an inverted yield curve?
when investors fear a recession is looming, they sell their stocks and buy bonds because bonds are safer. remember that the fed usually cuts the rates during a recession to encourage borrowing in order to stimulate the economy. also remember that a decrease interest rates will cause the bonds to increase in value. what causes the inverted yield curve is because investors will prefer to buy the longer term bonds. higher demand causes an increase in the value of the principal. but remember the interest rate for a particular bond never changes. if the principal increases but the interest rate stays the same, the yield is smaller for the next buyer (but for the current holders, the realized yield actually increases if they sell it). but note that the yield curve shows the yields the potential buyer will get. the confusion lies in the distinction between price and yield. just keep in mind that as demand goes higher, the price goes higher but the yield goes lower. think of yield as the potential for the buyer to make money. if it's expensive, then the potential to make money is lower.
why would investors prefer longer term bonds over short term bonds when they know a recession is looming and the fed will cut rates? that's because a change in rates will have a greater impact on the longer term bonds. why? let's say the interest rate of a 1 year bond decreases from 7% to 5%. if the principal is $100, then the value of the bond only increases $2 (refer to previous example for the computation). but if the bond has 10 years left until maturity, then the value has increased $2 X 10 = $20.
because investors prefer longer term bonds, the yields of the longer term bonds will be lower compared to the short term bonds. this causes the inverted yield curve .
V. why i don't think there will be a recession
historically an inverted yield curb signals a coming recession, but i think this time it's different.
many experts say that one of the causes of the inverted yield curve is that the fed irrationally raised rates last year. the fed was basing their decision on traditional metrics and ignored the slowdown in key industries such as auto, housing, transportation and industrial. the traditional metrics to gauge growth or inflation don't really apply that much nowadays because the economy is different. manufacturing is now more automated and we are entering an era of non ownership economy. people would rider use uber or lyft instead of buy a car. companies would rather use cloud services instead of buy their own servers. companies would rather hire freelancers and online virtual teams than setup an office and hire permanent workers. people would rather use airbnb than buy vacation homes.
when the fed raised rates, the long term bonds did not follow because investors were expecting a slowdown in the economy. investors thought that the central banks have increased interest rates to a level that will stifle the economy and cause a recession. investors also thought that the market boom has lasted for a very long time, and that a recession is due soon. but i think the inverted yield curve will reverse or normalize because the fed realized it's mistake and promised not to raise rates in 2019.
investors are also worried about the trade war with china. but note that the trade war is not an economic embargo. it's more of a tariff war. i'm sure both leaders will opt for a win-win situation than a lose-lose situation. the inverted yield curve is just temporary reflection of the trade war jitters. an inverted yield curve does not cause a recession, it's just a sign that investors are predicting a recession. because of the fear of a trade war, investors moved their stocks to long term bonds. the increase in demand of longer term bonds increased the prices and thus decreased the yield. so for now the longer term bonds have lower yields than the shorter term bonds, resulting in an inverted yield curve. but even that's just temporary.
what i find funny about the trade war is that what trump is imposing on china is actually china's ultimate dream and goal - an economy less dependent on exports.
i think the negative effects of a tariff war can now be easily offset by automation and AI. when the price of goods increases because of the tariff, the manufacturers can easily ramp up production to take advantage of the high prices. they can easily do this because of our astounding technological advancements. this will lower the cost of goods and stave off inflation.
there is also fear that china will stop exporting rare earth elements to the US. they don't know that just 50 miles south of las vegas there is a rare earth mine still intact and can quickly resume production and meet demand. it will also cause the value of arabelle's house to increase. worse case scenario is that your tv and iphone screens will just look duller if america can't get rare earth elements.
according to jim cramer - "another cause of the inverted yield curve that is unrelated to recession fears is the lack of a solid risk-free investment. developed countries in europe and asia have lower-yield, higher-risk bonds compared to US ttreasuries, which is viewed by many as the safest investment. the demand for treasuries keeps a bid under the bonds -- and the dollar -- and helps to drive down yields. but many investors aren't buying it. instead, investors are worried about the future. that can hurt confidence, both for businesses and consumers, which hurts spending and borrowing. this type of thinking can hurt the economy if enough people buy into it, and that's just what they're doing. investors are slowly but surely letting the bond market talk them into a recession and while the action in the bond market could encourage a rate cut from the fed, it won't happen until things worsen first. the stock market can continue lower until the decline in the rates slows".
with all the jobs disappearing due to automation and AI, the question we should be thinking about nowadays is - is it time for the government to start implementing universal basice income? ANDREW YANG FOR PRESIDENT !!!
VI. what i think of the huawei issue?
https://ian-crystal.blogspot.com/2019/06/rare-perspectives-on-huawei-issue.html
(for more of my knowledge bombs, click the "ian's knowledge bombs" banner at the top of this article and choose any article in the table of contents that piques your interest)
No comments:
Post a Comment