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← Introduction to the yield curve

Introduction to the treasury yield curve.

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Showing Revision 1 created 04/17/2011 by brettle.

  1. Welcome back.
  2. Before we proceed further and
    get a little bit better
  3. understanding of why maybe some
    of these investors were
  4. so keen on investing in mortgage
    backed securities,
  5. essentially loaning this money
    to all these people who are
  6. buying these ever appreciating
    houses, I think we need to a
  7. few more tools in
    our tool belt.
  8. So I'm going to introduce
    you to the concept
  9. of the yield curve.
  10. You might have heard
    this before.
  11. You might have heard people
    on CNBC talk about it.
  12. And hopefully, after about the
    next five or ten minutes, you
  13. will know a lot about
    the yield curve.
  14. So when most people talk about
    the yield curve, they're
  15. talking about the treasury
    yield curve.
  16. And what does that mean?
  17. What is even a treasury?
  18. So these treasury securities,
    whether they're T-Bills,
  19. treasury bills, treasury notes,
    or treasury bonds.
  20. These are loans to the
    federal government.
  21. And these are considered
    risk-free.
  22. Because if you lend to the
    federal government and they're
  23. running short of cash, all they
    have to do is increase
  24. taxes on us the people and they
    can pay back your debt.
  25. So in dollar denominated terms,
    the treasury bills,
  26. notes, and bonds are about as
    safe as you can get in terms
  27. of lending your money
    to anyone.
  28. So when most people talk about
    the yield curve, they're
  29. talking about the risk-free
    yield curve.
  30. And they're talking about the
    curve for treasuries.
  31. So first, a little bit
    of definitions.
  32. What is the difference between
    treasury bills, treasury
  33. notes, and treasury bonds?
  34. They're pretty much all loans
    to the government.
  35. But they're loans for different
    amounts of time.
  36. So if I give a loan to the
    government for $1,000 for six
  37. months, that will be
    a treasury bill.
  38. So I will give the government
    $1,000, the government would
  39. give me a treasury bill.
  40. And that treasury bill from the
    government is essentially
  41. just an IOU saying that I'm
    going to give you your money
  42. back in six months with
    interest. Similarly, if it's
  43. three months, it's a three
    month treasury bill.
  44. Treasury notes are loans that
    are from one year to 10 years.
  45. So on this graph that we're
    going to make using the actual
  46. yield curve rates, from zero
    to one year-- and actually
  47. there's no zero year
    treasury bill.
  48. Actually, the shortest
    one is one month.
  49. This would be something like
    here on our graph.
  50. So from one month to one year,
    these are T-bills.
  51. And this is just definitional.
  52. Then from one year to 10
    year, these are notes.
  53. Actually, I believe the one
    year itself is a note.
  54. Up to one year is a bill.
  55. Although, I might be
    wrong with that.
  56. Correct me if I'm wrong.
  57. That's just a definitional
    thing.
  58. From one to 10 year, these
    are called notes.
  59. And then when you go beyond
    10 years, these are called
  60. treasury bonds.
  61. These are just definitional
    things to worry about.
  62. So with that out of the way,
    let's talk about what the
  63. yield curve is.
  64. I'll just give you a simple
    thought experiment.
  65. If I'm lending money to someone
    for a month versus
  66. lending money to that person for
    a year, in which situation
  67. am I probably taking
    on more risk?
  68. Well, sure, if I'm lending
    someone for a month, I know
  69. only so much can happen
    in that month.
  70. So I would expect to be paid
    less interest. Not just
  71. obviously in dollar terms, but
    even adjusted for time, I
  72. would expect less interest
    for that month.
  73. And this is actually an
    important point to make.
  74. When I say that I'm charging
    6% interest for that month,
  75. that doesn't mean that after a
    month the person is going to
  76. pay me 6% on my money.
  77. It means that if I were to give
    that money to somebody
  78. for a month, and they
    were to pay it back.
  79. And then I were to give that
    money to, say, that same
  80. person, or another person, for
    a month, and I were to keep
  81. doing that for a year, then in
    aggregate I would get 6%.
  82. So that 6%, no matter what
    duration we talk about,
  83. whether one month, one year,
    five years, 15 years, when we
  84. talk about the interest rate,
    that's the rate that on
  85. average we would
    get for a year.
  86. It's the annualized
    interest rate.
  87. So going back to my question.
  88. If lend someone money, even the
    government, for a month,
  89. there's usually less
    risk in that.
  90. Because only so much
    could happen in a
  91. month versus in a year.
  92. In a year there might be more
    inflation, the dollar might
  93. collapse, I might be passing on
    better investments, I might
  94. need the cash in a year's time,
    while I have a lot of
  95. confidence that I don't need
    the cash in a month's time.
  96. So in general, you expect less
    interest when you loan money
  97. for a shorter period time than
    a longer period of time.
  98. And so let's draw the
    yield curve and see
  99. if this holds true.
  100. So I actually went
    to the treasury
  101. website, so that's treas.gov.
  102. And this is the yield curve.
  103. So they say on March
    14, so this is
  104. the most recent number.
  105. And I'm going to plot this.
  106. They say, if you lend money to
    the government for one month,
  107. you'll get 1.2% on that money.
  108. And remember, if it's $1,000
    it's not like I'm going to get
  109. 1.2% on that $1,000 just
    after a month.
  110. If I kept doing it for a year,
    this is an annualized number,
  111. I'll get 1.2%.
  112. And so for three months, I
    get a little bit less.
  113. And then for six months
    I get more.
  114. And then it does seem that the
    overall trend is that I expect
  115. more and more money as I lend
    money to the government for
  116. larger and larger
    periods of time.
  117. And this is a little interesting
    anomaly that you
  118. get a little bit more
    interest for one
  119. month than three months.
  120. And we'll do a more advanced
    presentation later as to why
  121. you might get lower yields for
    longer duration investments.
  122. That's called an inverted
    yield curve.
  123. So let's just plot this and
    see what it looks like.
  124. So you saw where
    I got my data.
  125. So they say for one month
    I'd get 1.2%.
  126. So this is one month.
  127. It'd be right about here.
  128. Three months I get about
    the same thing.
  129. For six months I get 1.32%.
  130. Maybe that's like here.
  131. One year, I get one 1.37%.
  132. Maybe it's here.
  133. Five years, I get 2.37%.
  134. So that's maybe like here.
  135. And these aren't all
    of the durations.
  136. I'm just for simplicity not
    going to do all of them.
  137. For 10 years, 3.44%.
  138. So maybe that's here.
  139. For 20 years, I get 4.3%.
  140. Like that.
  141. And then for 30 years,
    I get 4.35%.
  142. So the current yield curve looks
    something like this.
  143. And so you now hopefully at
    least understand what the
  144. yield curve is.
  145. All it is, is using
    a simple graph.
  146. Someone can look at that graph
    and say, well, in general what
  147. type of rates am I getting for
    lending to the government?
  148. On a risk-free free basis, or
    as risk-free as anything we
  149. can expect, what type of rates
    am I getting when I lend to
  150. the government for different
    periods of time?
  151. And that's what the yield
    curve tells us.
  152. And in general, it's
    upwardly sloping.
  153. Because, as I said, when you
    lend money for a longer period
  154. of time, you're kind of
    taking on more risk.
  155. There's a lot more that you
    feel that could happen.
  156. You might need that cash.
  157. There might be inflation.
  158. The dollar might devalue.
  159. There's a lot of things
    that could happen.
  160. So the next question
    is, well, what
  161. determines this yield curve?
  162. Well, when the treasury, the
    government, needs to borrow
  163. money, what it does is say, hey
    everyone we need to borrow
  164. a billion dollars from
    you, because we
  165. can't control are spending.
  166. And they say we're going to
    borrow a billion dollars in
  167. one month notes.
  168. So this is one month notes.
  169. They're going to borrow
    a billion dollars.
  170. And they have an auction.
  171. And the world, investors from
    everywhere, they go in, they
  172. say, well, this is a
    safe place to put
  173. my cash for a month.
  174. And depending on the demand,
    that determines the rate.
  175. So if there are a lot of people
    who want to buy those
  176. one month treasuries, the rate
    might be a little bit lower.
  177. Does that make sense to you?
  178. Think about it.
  179. If a lot of people want to buy
    it, there's a lot of demand
  180. relative to the supply.
  181. So the government has to pay a
    lower interest rate on it.
  182. Similarly, if for whatever
    reason people don't want to
  183. keep their money in the dollar,
    they think the U.S.
  184. might default on their debt
    one day, and not that many
  185. people want to invest in the
    treasury, then that auction,
  186. the government is going to have
    to pay a higher interest
  187. rate to people for them
    to loan money to it.
  188. So maybe then the auction
    ends up up here.
  189. And similarly, the government
    does auctions for all of the
  190. different durations.
  191. And duration, I just mean
    the time period you're
  192. getting the loan for.
  193. So they do it for one month,
    three months, six months, one
  194. year, two year, three
    year, et cetera.
  195. Once the government has done
    that auction-- You give the
  196. money to the government,
    they give you an
  197. IOU called a T-bill.
  198. Then you could trade it
    with other people.
  199. And that's going to determine
    the rate in the short term.
  200. So the government does
    the auction.
  201. But then after the auction,
    and a lot of people had
  202. demand, but then a lot of
    people get freaked out.
  203. And the public markets, when you
    try to sell that treasury,
  204. will then expect.
  205. a higher yield.
  206. I know that might be a little
    complicated now.
  207. And I always start to jumble
    things when I run out of time.
  208. But hopefully at this point you
    have a sense of what the
  209. yield curve is.
  210. You have a sense of what
    treasury bills, treasury
  211. notes, and treasury bonds are.
  212. And you have some intuition
    on why the yield
  213. curve has this shape.
  214. See you in the next video.