Ep.78- Why the Fed is at a Crossroad Between a Stock Bubble or a Housing Bubble (Hint: the Inverted Yield Curve)

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By now, you may have heard from the news that many experts worry a recession may be coming because there’s an inverted yield curve. Statistically, this leading indicator has only been wrong in predicting a looming recession once in the last 70 years. But wait… what exactly is an inverted yield curve, and how does it put the Federal Reserve in a pickle?

Chart Source: from Timothy Chong

Chart Source: from Timothy Chong

WHAT IS AN INVERTED YIELD CURVE EXACTLY ?

Let’s start with the technical definition. An inverted yield curve simply refers to a yield curve that’s upside down. In general, upside down never sounds good in anything, and it is no exception with the yield curve.

But what is a yield curve? A yield curve refers to the different interest rates based on the maturity of Treasury bonds (1 yr, 5 yr, 30 yr, etc.). If you plot them, it becomes a curve, normally with the longest maturity one (30year bond) having the highest rate.

But why? Think about this, if you have $1,000 to invest in something, and two people pitched you the same idea, one wants to pay you back in 1 year, and another wants to pay back in 5 years, which one do you want to charge more? Of course, the 5 years one, because that person is holding onto your money for longer.

When the yield curve is inverted, it means the interest rate on the longest maturation (typically 30-year Treasury bond) is lower than the shortest one (typically the 5-year Treasury bond). It like the person who took your money for 5 years pays you back less than the person who borrowed it for 1 year. When this happens, historically it means a recession is coming.

WHO CONTROLS THE SHORT TERM INTEREST RATE VS. LONG TERM INTEREST RATE

There are two components to the yield curve, the short term interest rate and the long term interest rate. The short term interest rate is largely determined by the Federal Reserve, just because they say so. It’s like how like Apple has the power to set its Iphone Xs at $999,. Similarly, the Federal has the direct and absolute power to set the short interest rate to whatever it likes. But the long term interest rate is set by the market,kinda like how a used Iphone works. If you try to buy a used Iphone on Amazon, the market determines the price.

INVERTED YIELD CURVE IN PLAIN ENGLISH

An inverted yield curve actually means people are already preparing for a storm, whether it happens or not. It is a preemptive measure to protect one’s money, by buying more and more long term Treasury bonds, which causes the long-term rate part of the yield curve to go down.

Why are people buying more long term Treasury bond then? Because it’s seen as the safest thing in the world. Like the Lannisters, the U.S government always pays its debt. Okay. Let’s go one level deeper. Why do people want to move their money to the safest place all of a sudden, especially now? It’s because people expect something bad may happen to their money if left elsewhere, particularly stocks, because that’s most people’s alternative.

A SELF-FULFILLING PROPHESY THAT WILL LEAD TO A STOCK CRASH

An inverted curve, in my opinion, could easily lead to a self-fulfilling prophesy that leads to a stock crash. Here are the steps.

  1. People (wave 1, the earliest people who think a recession may come) buy long-term Treasury bond to protect their assets, because they think the economy is turning sour soon.

  2. By buying more long-term Treasury bond, these people have to dump their equity stocks, causing the volatility in the stock market.

  3. When a slightly later group of people (wave 2) see the volatility in the stock market, amplified with the message of a looming recession by things like an inverted yield curve, they also begin to sell their stocks, causing further drop in the stock market.

  4. When these wave 2 group people sell off stocks, they need another safe place to park their money, which is also likely the U.S Treasury bonds, causing the long-term interest rate to go even lower, which means the yield curve stays inverted.

  5. It continues with people in wave 3, wave 4 and more, as more people buy into this.

  6. This ultimately leads to a complete run on the stock market, causing a stock crash.

THE FEDERAL RESERVE CAN SAVE US FROM A STOCK CRASH, BUT AT THE COST OF RISKING A HOUSING BUBBLE

Remember the 2008 economic crisis? Back then, the Federal Reserve bought over 2 trillion dollars worth of long term Treasury bond, in order to stimulate the economy. In doing so, the Fed has become a huge player, which has the power to change the long term interest rate. All they have to do is either starting selling the Treasury bond back to the market, or completing stop purchasing new Treasury bond.

Having the Fed sell off the huge inventory of Treasury bonds comes with a huge cost, as it could drive up the long term interest rate too much. While an inverted yield curve is a psychological warning, that yet has any realized impact on the economy, a rising long-term interest rate will actually impact you and me. It will hit the housing market particularly hard, by making it more expensive for people to afford a house. This then could lead to an acceleration of the housing bubble burst.

In other words, would the Fed risk saving us from a stock crash, by risking a housing bubble burst? I don’ t think so, because a stock crash may hurt the rich and some upper-middle-class, but a housing bubble will hit the average joe.