Newspaper headlines – financial crisis on 2008

The CRISIS is COMING!! But WHEN?

When is the next financial crisis coming? Some observers have been predicting the next crisis as early as 2013 but they would have missed the strongest bull run in the history of Planet Earth. Ok, maybe just Planet US.

The truth is no one can predict the market accurately. All we can do is to assign a probability. For example, if the banks are calling back loans and the domestic spending is decreasing, those are indicators of a tightening market. Hence, the PROBABILITY of a financial crisis is higher.

While there are many tools out there to predict the next crisis, I personally view this one tool as the most reliable.

The Yield Curve

Now, before your eyes roll over with a death stare, grant me 5 mins to explain it in simple terms. Let’s break it down into the individual words. Yield and Curve.

What is Yield?

In short, yield is the interest that you will be receiving from an investment. In this case, we are referring to the interest of US Treasury Note. It is also known as Government Bonds, Government Securities, Treasury Bonds etc. All the same thing. When you buy a US Treasury Note, you are lending money to the US Government and they will pay you interest, aka the yield.

For example, right now, if you were to buy a US 10 year Treasury Note, the yield is about 3% each year. So if you bought $100 worth of US 10 year Treasury Note, on average you will receive $3 each year as interest (the yield) for 10 years.

Source: bondsupermart.com

What is Curve?

The curve is referring to the difference in the yield of Treasury Note from different timeframe. There are many types of Treasury Note. The longest is 30 years while the shortest is 1 month.

Now with different timeframes, which one has the higher yield? Common sense may tell you that the longer the Treasury Note, the higher the yield. Make sense? Yes, that is correct. Most of the time, a 30 year US Treasury Note will give you a higher yield that a 1 month US Treasury Note. Therefore, it is a curve.

Source:bondsupermart.com

How to Use Yield Curve?

Before I start, I want to confess that yield curve is a complex economic baboon that has many factors but I am always about simplifying things to make it useful, so for the economists out there, please don’t be pissed.

The yield curve is useful in forecasting financial crisis because it tells you something about the market sentiments. While the normal yield curve is a hockey shape, it can also be flat or even inverted!

Source:corporatefinanceinstitute.com

When the yield curve is flat, the short term interest rate is catching up with the long term interest rate. This means it will be more expensive to take loans from the bank, and business growth are likely to slow down without loans. Another way to look at it is when people are less optimistic about long term investments.

Source:corporatefinanceinstitute.com

When this continues further, you can even see the yield curve inverts. The short term interest rate is higher than long term interest rate. This means the market is feeling very uncertain about the long term future of the market, choosing to only invest in the near term and getting ready to run off when the market is bad.

Why is Yield Curve Reliable?

This is about track record. From a Duke University research, it was shown that a flat or inverted yield curve has preceded the last 7 recessions

“the model of comparing the 90-day bill to the five-year Treasury has an excellent track record for identifying recessions.”

So when the yield curve starts to flatten or invert, I will be on high alert because it could signal a pending financial crisis.

I found really cool website that shows the yield curve changing as the market changes. You can see below that for the Dotcom Bubble in 2001 and Global Financial Crisis in 2008, it was preceded by a flatten/inverted yield curve.

Source: stockcharts.com

Where is the Yield Curve Now?

Source: stockcharts.com

Looking at the chart below, i think the curve is still ok. Not inverted yet but definitely flattening. So the probability of a financial crisis happening, based on yield curve, is not that high yet. As an investor, the best thing you can do now is only invest in strong companies with good financials and growth prospects, and at the same time, keep some money aside ready to deploy them when the time comes.

Who knows when the financial crisis will really come, it could be tomorrow even with a normal yield curve. After all, the yield curve is only a tool thats has yet to be proven wrong. But I prefer to have probability on my side. Hope you find this useful in your investment journey!

See you soon!

Investing Always,

Pete

Please refer to the disclaimer here