Saber Capital: Interest Rate Fears And The Dreaded Yield Curve

The Dreaded Inverted Yield Curve

It’s common sense that if you are lending money to someone for a decade, you are naturally going to want a higher interest rate than a short-term loan that will be repaid in a few months. However, on certain occasions a strange phenomenon occurs: lenders to the US government demand less return for a long-term loan than they do for a short-term one. This is the much feared “inverted yield curve”, which, as famed investor Stanley Druckenmiller likes to say, has predicted 9 of the last 4 recessions.

This week, the 10-year US Treasury yield dropped below the 2-year. Incredibly, the 30-year Treasury traded at a 2% yield yesterday. Put another way, this 30-year bond trades at 50 times earnings, and these earnings are obviously guaranteed, but they’re also guaranteed not to grow. Treasuries trade at similar valuation levels to high flying software stocks these days.

There are lots of reasons why the pundits believe that a yield curve inverts, but one reason is when investors become fearful, they plow their money into longer term bonds as a “safe haven”. The implicit logic is that investors would rather lock in a sure 2% return than risk getting even less if the economy turns south and rates fall further. One asset that allows you to “lock in” a much higher interest rate than Treasury bonds is WFC at $44 per share. As mentioned, the dividend yield is 4.6% and unlike the bonds, this stream of cash can and likely will grow over time. More importantly, if we add the buyback "yield" (described here), we're getting a total yield of an incredible 16% at the current price.

Why Are Banks Cheap?

One reason is the fear that interest rates go lower and compress profit margins.

Banks make money in two main ways: the first is gathering funds by paying interest to depositors and then lending or investing that money at higher interest rates, pocketing the spread (“borrow at 3, lend at 6, play golf at 3″… the classic business of a bank is a pretty straightforward business). The second main category of revenue is called “non-interest income”, which is basically everything else including asset management, trading revenue, investment banking, and other fee-based income that banks collect from their customers.

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