Personal Wealth Management / Market Volatility

Ken Fisher Explains the Yield Curve and Why it Matters

Fisher Investments’ founder, Executive Chairman and Co-Chief Investment Officer Ken Fisher discusses the yield curve. Ken believes the yield curve is important economic indicator because it correlates with banks’ profitability and willingness to lend. He says a steep yield curve—where interest received on long-term loans exceeds banks’ short-term deposit costs—incentivizes lending and drives economic activity. Conversely, Ken says, when short-term rates exceed long-term rates (an inverted yield curve), lending conditions can suffer—potentially signaling a recession ahead.

Ken believes recent concerns on one yield curve measure—the narrowing spread between the 2- and 10-year US treasury rates—are misguided because it does not accurately reflect banks’ profit margins. He suggests using the 90-day and 10-year spread is a better yield curve measure and appropriately accounts for banks’ short-term borrowing costs relative to long-term loans.

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Ken Fisher: a lot of talk lately about the yield curve and, you know, not a lot of common sense about what is really behind it, what it means, et cetera. The most common interpretation recently, which is a bad wrong one, is that the yield curve, as represented by the two-year government bond rate subtracted from the ten-year government bond rate, has narrowed, and as it narrows, it might invert. And there is this legendary, partly true, partly false mythology— because a lot of mythologies have some truth to them—that inverted yield curve implies recession. And that's the fear, the bugaboo, the big thing that people chatter about.

Ken Fisher: The yield curve, of course, is a representation of government debt all along the maturity schedule, from very short-term debt all the way out to 30-year debt. And it's a continuum because there's all those maturities, and there's an interest rate associated with every one of them. And traditionally when I was young, you learned to think of it instead in terms of very short-term debt and the interest rate on it compared to the ten-year government bond. And that when that got flat and or short rates—flat meaning the same rate—or short rates got above long rates, that that could signal recession and has happened often before we've had recession.

Ken Fisher: But that's not what's important. What's important is what that represents that would cause recession. What that represents that would cause recession is simple and it's easily understood. The core business of banking has always and everywhere been taking in short term deposits as the basis for making long term loans. And the fatter the spread between the two of them, the bigger the profitability on subsequent loans that banks would make other things equal.

Ken Fisher: So, when that spread is big and getting bigger, banks become ever more eager to lend. And it is the lending that is expansionary, if you will. It is the lending that makes people have ready money to spend on projects, purchases, this and that and the other to amplify what they're doing. When the banks won't lend, that becomes problematic. And when you move to where short-term rates are higher than long term rates, the only way a bank can make money on a loan is if it lends to a less-creditworthy borrower at a higher rate than that that it gets its deposits from, which is inherently risky. So, because it's the lending that matters, that tells you a couple of things. One, you shouldn't pay attention to the two-year, ten years spread because very little of the lending that's ever done is based on two-year time deposits. Most of the lending that's done is based on shorter deposits. Which is why you should go back to the concept of short term, like 30 days versus ten-year, 90 days versus ten years.

Ken Fisher: And that curve is not terribly narrow right now. It's adequately steep. It's almost 2% and at that, when you think about that, it leaves you, if you will, more comfortable, but it also leaves the banks more comfortable because they've got a reasonable margin to borrow at and lend against and make money so that they are ready to lend, and that's good and we should want them to be.

Ken Fisher: So, don't get carried away with the two to ten years spread the way so many people do. That's a wrong-headed way to analyse it. And don't think about the curve itself, the yield curve itself is what's important. It's what it represents in terms of bank lending. It's the bank lending that's important, and if you want you just simply would do well on an ongoing basis to do a Google search on annual rate of bank loans, both domestically and globally, to find out how that's proceeding over time. But I will tell you right now it's proceeding very well. Thank you. Thank you for listening to me.

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A series of disclosures appears on screen: “Investing is Securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized investment advice or a reflection of the performance of fisher investment or its clients. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein.

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