Introduction to the yield curve Video

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Introduction to the yield curve

Welcome back, before we proceed further and get a little bit understanding of why maybe some of these investors so keen in investing in mortgage bank securities is essentially loaning this money to all of these people who are buying this 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 talked about it. And hopefully after about the next 5 or 10 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 is that mean? What is even a treasury? So in this treasury securities, whether they're T bills, treasury bills, treasury notes, or treasury bonds. So they all start with the treasury. So there are T bills, T notes, and T bonds. All these are loans to the Federal Government. And 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 anyone. So when most people talked about the yield curve, they're talking about the risk free yield curve. And they're talking about the curve for treasuries. So first 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 they're loans for different amount of time. So if I give a loan for the government for $1000, say I give a loan for 6 months. That will be treasury bills, so I will give the government the $1000. The government will give me treasury bills. And that Treasury bill from the government is essentially just an IOUs saying that I'm to give you your money back in 6 months with interest. Similarly, if its 3 months, it’s a 3 month treasury bill. Treasury notes are loans that are from 1 year to 10 years. So in this graph that were going to make using the actual yield curve rates from 0 to 1 year, actually there is no 0 year treasury bill. Actually the shortest one is 1 month. So it will something like here on our graph. So from 1 month to 1 year, these are T bills. And this is just definitional. Then from 1 year to 10 years, these are notes. Actually the 1 year, I believe the 1 year itself is a note. I think so, up to 1 year is a bill. Although I might be wrong in that, correct me if I'm wrong. That’s just a definitional thing. From 1 to 10 years, these are called notes. And when you go beyond 10 years, these are called treasury bonds. These are just definitional things to worry about. So with that out of the way, let's talk about what the yield curve is. 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, 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 adjusted for a time. I would expect less interest for that month. So, this is actually an important point to make, when I say that I'm targeting 6% interest rate for that month. That doesn’t mean that after a month, that 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, and they were to pay it back and I were to give that money to that same person or another person for a month and I were to keep doing that for a year. Then in aggregate, I would get 6%. So that 6%, no matter what duration we talked about, whether 1 month, 1 years, 5 years, 15 years. When we talked about the interest rate, that’s the rate that on average we would get for a year. It’s the annualize 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. They might be passing on a 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 treas.gov, and this is the yield curve. So they say in 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 1 month. You’ll get 1.2% on that money. And remember, if its $1000, it’s not like I'm going to get 1.2% on that $1000 just after a month. If I kept doing it for a year, this is an annualize number, I’ll get 1.2%. And so for 3 months, well for 3 months, I get a little bit less. And then for 6 months, I get more. And it does seem the overall trend is I expect more and more money as I lend money to the government for larger and larger periods of time. And this is a little interesting anomaly that you get a little bit more interest for 1 month than 3 months. And we’ll do more advance 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 see what it looks like. So you saw where I got my data. So they say for 1 month I get 1.2%. So this is 1 month, it would be right about here. 3 months, I get about the same thing. For 6 months, I get 1.32, that’s like here. 1 year, I get 1.37, and its here. 5 years, I get 2.37, so that’s maybe like here. 10 years, and these aren't all of the durations. Just for simplicity, I'm not going to do all of them. For 10 years, 3.44, so maybe that’s here. 20 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. Now, hopefully you at least understand what the yield curve is. All it is, is using a simple graph. Someone can look at that graph and say, well, in general what type of rates am I getting for lending the government at 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, it’s upwardly sloping. Because as I said, when you lend money for a longer period of time, you're kind of taking on more risk. There's a lot more that you feel that could happen. You might need that cash, there might be inflation. The dollar might devalue. There's a lot of things that could happen. So the next question is, what determines this yield curve? Well, when the Fed, well not the Fed, sorry. When the Treasury, the government, needs to borrow money. What it does, it say, hey everyone we need to borrow $1 billion from you because we can't control our expending. And they’ll say, were going to borrow $1 billion in 1 month’s notes. So this is 1 month’s notes. They’re going to borrow $1 billion. And they have an auction. And the world, investors from everywhere, they go in. they say, well, 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 who want to buy those 1 month treasuries, the rate might be a little bit lower. Right? 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, for whatever reason, people don’t want to keep their money in the dollar. They think the US might default on their debt 1 day, and not that many people want to invest in the treasury. Then that auction, the government has 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 here. And similarly the government does auctions for all of the different durations. And duration I just mean the time period you're getting the loan for. So I’ll do it for 1 month, 3 months, 6 months, 1 years, 2 years, 3 years, et cetera. Once the government has done that auction, then those treasuries, so you the money to the government. They give you an IOU, called the T bill. Then you can trade it with other people. And that’s going to determine the rate in the short term. So the government does the auction. Then after the auction, say, and a lot of people had demand. But then a lot of people will get freaked out and the public market, when you try to sell that treasury, will then expect a higher yield. I know that might be a little complicated now and I always start to jumble things when I'm running out of time. But hopefully, 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.

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Welcome back, before we proceed further and get a little bit understanding of why maybe some of these investors so keen in investing in mortgage bank securities is essentially loaning this money to all of these people who are buying this 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 talked about it. And hopefully after about the next 5 or 10 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 is that mean? What is even a treasury? So in this treasury securities, whether they're T bills, treasury bills, treasury notes, or treasury bonds. So they all start with the treasury. So there are T bills, T notes, and T bonds. All these are loans to the Federal Government. And 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 anyone.
So when most people talked about the yield curve, they're talking about the risk free yield curve. And they're talking about the curve for treasuries. So first 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 they're loans for different amount of time. So if I give a loan for the government for $1000, say I give a loan for 6 months. That will be treasury bills, so I will give the government the $1000. The government will give me treasury bills. And that Treasury bill from the government is essentially just an IOUs saying that I'm to give you your money back in 6 months with interest. Similarly, if its 3 months, it’s a 3 month treasury bill.
Treasury notes are loans that are from 1 year to 10 years. So in this graph that were going to make using the actual yield curve rates from 0 to 1 year, actually there is no 0 year treasury bill. Actually the shortest one is 1 month. So it will something like here on our graph. So from 1 month to 1 year, these are T bills. And this is just definitional. Then from 1 year to 10 years, these are notes. Actually the 1 year, I believe the 1 year itself is a note. I think so, up to 1 year is a bill. Although I might be wrong in that, correct me if I'm wrong. That’s just a definitional thing. From 1 to 10 years, these are called notes. And when you go beyond 10 years, these are called treasury bonds. These are just definitional things to worry about.
So with that out of the way, let's talk about what the yield curve is. 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, 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 adjusted for a time. I would expect less interest for that month. So, this is actually an important point to make, when I say that I'm targeting 6% interest rate for that month. That doesn’t mean that after a month, that 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, and they were to pay it back and I were to give that money to that same person or another person for a month and I were to keep doing that for a year. Then in aggregate, I would get 6%. So that 6%, no matter what duration we talked about, whether 1 month, 1 years, 5 years, 15 years. When we talked about the interest rate, that’s the rate that on average we would get for a year. It’s the annualize 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. They might be passing on a 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 treas.gov, and this is the yield curve. So they say in 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 1 month. You’ll get 1.2% on that money. And remember, if its $1000, it’s not like I'm going to get 1.2% on that $1000 just after a month. If I kept doing it for a year, this is an annualize number, I’ll get 1.2%. And so for 3 months, well for 3 months, I get a little bit less. And then for 6 months, I get more. And it does seem the overall trend is I expect more and more money as I lend money to the government for larger and larger periods of time. And this is a little interesting anomaly that you get a little bit more interest for 1 month than 3 months. And we’ll do more advance 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 see what it looks like. So you saw where I got my data. So they say for 1 month I get 1.2%. So this is 1 month, it would be right about here. 3 months, I get about the same thing. For 6 months, I get 1.32, that’s like here. 1 year, I get 1.37, and its here. 5 years, I get 2.37, so that’s maybe like here. 10 years, and these aren't all of the durations. Just for simplicity, I'm not going to do all of them. For 10 years, 3.44, so maybe that’s here. 20 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. Now, hopefully you at least understand what the yield curve is. All it is, is using a simple graph. Someone can look at that graph and say, well, in general what type of rates am I getting for lending the government at 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, it’s upwardly sloping. Because as I said, when you lend money for a longer period of time, you're kind of taking on more risk. There's a lot more that you feel that could happen. You might need that cash, there might be inflation. The dollar might devalue. There's a lot of things that could happen.
So the next question is, what determines this yield curve? Well, when the Fed, well not the Fed, sorry. When the Treasury, the government, needs to borrow money. What it does, it say, hey everyone we need to borrow $1 billion from you because we can't control our expending. And they’ll say, were going to borrow $1 billion in 1 month’s notes. So this is 1 month’s notes. They’re going to borrow $1 billion. And they have an auction. And the world, investors from everywhere, they go in. they say, well, 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 who want to buy those 1 month treasuries, the rate might be a little bit lower. Right? 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, for whatever reason, people don’t want to keep their money in the dollar. They think the US might default on their debt 1 day, and not that many people want to invest in the treasury. Then that auction, the government has 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 here. And similarly the government does auctions for all of the different durations. And duration I just mean the time period you're getting the loan for. So I’ll do it for 1 month, 3 months, 6 months, 1 years, 2 years, 3 years, et cetera.
Once the government has done that auction, then those treasuries, so you the money to the government. They give you an IOU, called the T bill. Then you can trade it with other people. And that’s going to determine the rate in the short term. So the government does the auction. Then after the auction, say, and a lot of people had demand. But then a lot of people will get freaked out and the public market, when you try to sell that treasury, will then expect a higher yield. I know that might be a little complicated now and I always start to jumble things when I'm running out of time. But hopefully, 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.

Transcription by: Scribe4you Transcription Services