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Current time:0:00Total duration:9:56

Introduction to the yield curve

Video transcript

welcome back before we proceed further and and get a little bit better understanding of why maybe some of these investors were so keen on investing in mortgage-backed securities essentially loaning this money to all of these people who are buying these ever appreciating houses I think we need a few more tools in our tool belt so I'm going to introduce you to the concept of the yield curve you might have heard this before you might have heard people on CNBC talk about it and hopefully after about the next five or ten minutes you will know a lot about the yield curve so when most people talk about the yield curve they're talking about the Treasury yield curve and what what is what what does that mean what is even a Treasury so these Treasury securities whether they're t-bills Treasury bills Treasury notes or Treasury bonds so you know they're all start with a Treasury so there's t bills T notes and T bonds all these are are these are these are loans to the federal government and these are about these are considered risk-free because if you lend to the federal government and they're running short of cash all they have to do is increase taxes on us the people and they can pay back your debt so in dollar denominated terms the Treasury bills notes and bonds are about as safe as you can get in terms of lending your money to to anyone so when most people talk about the yield curve they're talking about the risk-free yield curve and they're talking about the and they're talking about the curve for Treasuries so first a little bit of a little bit of definitions what is the difference between Treasury bills Treasury notes and Treasury bonds they're pretty much all loans to the government but their loans for different amounts of time so if I loan if I give a loan to the government for $1,000 for any say I give a loan for six months that will be a Treasury bill so I will give the government $1,000 the government will give me a Treasury bill and that Treasury bill from the government is essentially just an IOU saying that I'm going to give you your money back in six months with interest similarly if it's three months it's a three month Treasury bill Treasury notes are loans that that are from 1 year to 10 years so on this graph that we're going to make using the actual the actual yield curve rates from zero to one year and actually there's no zero year Treasury bill it's actually the shortest one is one month so it'd be something like here on our graph so from one month to one year these are T bills T bills and this is just definitional then from 1 year to 10 year these are notes actually the 1 year I believe the 1 year itself is a note so just I think so up to 1 year is a bill although I might be wrong on that correct me if I'm wrong that's just a definitional thing from what a 10 year these are called notes and then when you go beyond 10 years these are called Treasury bonds these are just definitional things to to worry about so with that out of the way let's talk about what the yield curve is so when I I'll just give you a simple thought experiment if I'm lending money to someone for a month versus lending money to that person for a year in which situation am i probably taking on more risk well sure if I'm lending someone for a month I know I'm going only so much can happen in that month so I would expect to be paid less interest not just obviously in dollar terms but even on a you know adjusted for time I would expect less interest for that month so when when I tie and this is actually an important point to make when I say that I'm charging 6% interest for that month that doesn't mean that after a month the person is going to pay me 6% on my money it means that if I were to give that money to somebody for a month then they were to pay it back and then I were to give that money to say that same person or another person for a month and I were to keep doing that for a year then an aggregate I would get 6% so that six percent no matter what duration we talk about whether one month 1 year 5 years 15 years when we talk about the interest rate that's the rate that on average we would get for a year it's the annualized interest rate so going back to my question if I lend someone money even the government for a month there's usually less risk in that because only so much can happen in a month versus in a year in a year there might be more inflation the dollar might collapse I might be passing on better investments I might need the cash in a year's time well I have a lot of confidence that I don't need the cash in a month's time so in general you expect less interest when you loan money for a shorter period of time than a longer period of time and so let's draw the yield curve and see if this holds true so I actually went to the Treasury website so that's Trez gov and this is the yield curve so they say on march 14th so this is the most recent number and I'm going to plot this they say if you lend money to the government for one month you'll get one point two percent on that money and and remember if it's a thousand dollars it's not like I'm going to get one point two percent on that thousand dollars just after a month if I kept doing it for a year this is an annualized number I'll get one point two percent and so for three months well for three months I get a little bit less and then for six months I get more and then it does seem that the overall trend is that I expect more and more money as I lend money to the government for larger and larger periods of time and this is it a little interesting anomaly that the that you get a little bit more interest for one month than three months and we'll do a more advanced presentation later as to why you might get lower yields for longer duration investments that's called an inverted yield curve but let's just plot this and just see what it looks like so you saw where I got in my data so they say for one month I'd get one point two percent so this is one month would be right about here three months I get about the same thing for six months I get one point three two maybe that's like here one year I get one point three seven maybe it's here five years to five years I get two point three seven so that's maybe like here ten years and these aren't all of the durations I'm just just for simplicity not going to do all of them for ten years three point four four so maybe that's here three or four for twenty years I get 4.3 like that and then for 30 years I get 4.35 like that so the current yield curve looks something like this and so you now hopefully you at least understand what the yield curve is all it is is you know using a simple graph someone can look at that graph and say well in general what type of rates am I getting for lending government to at a risk-free on a risk-free basis or as risk-free as anything we can expect what type of rates am I getting when I lend to the government for different periods of time and that's what the yield curve tells us and in general its upwardly sloping because as I said when you lend money for a longer period of time you're you're kind of taking on more risky there's a lot more that you feel that could happen you might need that cash you might you might you know there might be inflation the dollar might devalue there's a lot of things that that could happen so the next question is well what what determines this yield curve well when the Fed wrapped the Fed sorry when the Treasury the government when the government needs to borrow money what it does is say well you hey everyone we need to borrow a billion dollars from you because we can't control our spending and they say we're going to borrow a billion dollars in one month notes so they're gonna this is one month notes they're going to borrow a billion dollars and they have an auction and the world investors from everywhere they go in they say well this is you know this is a safe place to put my cash for a month and depending on the demand that determines the rate so if there are a lot of people if there are a lot of people who want to buy those one-month Treasuries the rate might be a little bit lower right well does that make sense to you think about it if a lot of people want to buy it there's a lot of demand relative to the supply so the government has to pay a lower interest rate on it similarly if for whatever reason people don't want to keep their money in the dollar they think you know the US might default on their debt one day and not that many people want to invest in the Treasury then that auction the government is going to have to pay a higher interest rate to people for them to loan money to it so maybe then the auction ends up up here and similarly the government does auctions for all of the different durations and duration I just mean you know the time period that you're getting the loan for so they do it for one month three months six month one year two year three year etc once the government has done that auction then it those Treasury so you know you give the money to the government they give you an IOU called a t-bill then you could trade it with other people and that's going to determine the rate in the short term so the government does the auction but then after the auction say you know and a lot of people have demand but then a lot of people get freaked out and the public markets when you try to sell that Treasury will then expect a higher yield I know that might be a little complicated now and I and I always start to jumble things when I run out of time but hopefully at this point you have a sense of what the yield curve is you have a sense of what Treasury bills Treasury notes and Treasury bonds are and you have some intuition on why the yield curve has this shape see you in the next video