CARDIFF GARCIA, HOST:
Back in March, something happened that we on THE INDICATOR had been saying could happen ever since we launched the show about a year and a half ago. The yield curve inverted.
STACEY VANEK SMITH, HOST:
The yield curve.
GARCIA: Try to contain your excitement.
VANEK SMITH: (Laughter) So when we say the yield curve inverted, what we mean is that the long-term interest rates paid by U.S. government bonds, or Treasurys, are lower than the interest rates paid by short-term U.S. government bonds. And for the past six decades, whenever that has happened, whenever the yield curve has inverted, it has been a sign that the country will go into a recession within about a year or two.
GARCIA: Now, if you're a new listener, you might not know that I am totally fascinated - Stacey would say obsessed...
VANEK SMITH: It was going to say fascinated? OK, sure, we'll go with fascinated.
GARCIA: ...And she wouldn't necessarily be wrong - by the yield curve, not because it is a perfect predictor...
VANEK SMITH: Talks about it all the time, constantly.
GARCIA: Occasionally. And not because it's a perfect predictor of a recession - there is no such thing - but just because the yield curve has such a great track record as a recession forecaster, and also because there are interesting questions, and even doubts, about whether that streak of perfect recession forecasting is going to continue.
VANEK SMITH: Would you say that the yield curve is practically perfect in every way?
GARCIA: I would not say that. I have been careful not to say that.
VANEK SMITH: I know. I know. But, you know, a lot of listeners have emailed us, specifically you, Cardiff, with a bunch of questions about the yield curve because you are so fascinated by it. And today on THE INDICATOR FROM PLANET MONEY, we are going to answer them. I'm Stacey Vanek Smith.
GARCIA: You're Sassy Vanek Smith is what you are. And I'm Cardiff Garcia.
VANEK SMITH: I don't even know how to respond to that.
GARCIA: Those questions that our listeners sent us were all really smart. But in some cases, those questions were also asked with just as much sass and sarcasm as Stacey's giving me right now.
VANEK SMITH: Oh, there's so much more where that came from.
GARCIA: I know there is.
VANEK SMITH: Brace yourself, Cardiff.
GARCIA: So to channel that spirit of inquisitive sarcasm, we are going to paraphrase our listeners' questions and have them read aloud by producer Darius Rafieyan, who just has a phenomenal sarcastic voice.
VANEK SMITH: That's true.
DARIUS RAFIEYAN, BYLINE: Jeez, Cardiff, don't cry about it.
GARCIA: That's him. And after the break, sarcastic questions and our answers.
(SOUNDBITE OF MUSIC)
GARCIA: OK, for this episode, if you want a primer on the basics of the yield curve, we're actually going to encourage new listeners to go back and listen to our earlier episodes about it. But here's what you need to know for now.
The yield curve shows the interest rates that are paid by the different kinds of U.S. Treasurys. So there's a three-month Treasury, a one-year Treasury, a five-year Treasury and so on. And, for example, if you buy a five-year Treasury, then at the end of five years, you get your money back, plus you get paid some interest on your money.
VANEK SMITH: And when the economy is expected to do well, longer-term Treasurys should pay a higher interest rate than shorter-term Treasurys. So the five-year Treasury should pay an interest rate that is higher than the three-month Treasury.
And this makes sense - right? - because if you buy a five-year Treasury, you have to wait five years to get your money back. Your money is locked in the Treasury, so you'd expect to be paid a higher interest rate than if you only had to wait three months to get your money back.
GARCIA: But when the economy is not expected to do well, the yield curve can invert. And all that means is that longer-term Treasurys start paying lower interest rates than short-term Treasurys because something is off. And the reason is that long-term interest rates tend to fall when investors expect slower economic growth in the future.
And, in fact, every time the yield curve has inverted over the past six decades, a recession has shortly followed. That's happened seven times throughout those decades. And the yield curve - it's inverted now. So if it happens again, it would be the eighth straight time.
With all that said, sarcastic Darius, what is your first question?
RAFIEYAN: Correct me if I'm wrong, but the yield curve inverted way back in March. So is there a reason you waited till now to do a show about it?
GARCIA: OK, fair point.
VANEK SMITH: Oh, good question.
GARCIA: Here's the thing. The first scholar to discover the link between the inversion of the yield curve and recessions is named Campbell Harvey of Duke University. And according to his research, in the past, the recession forecast has been triggered only when the yield curve has been inverted for a full quarter, and, specifically, a calendar quarter, which means the same quarters of the year that we follow for other economic indicators.
So the first quarter is the first three months of the year. The second quarter is the next three months, and so forth.
VANEK SMITH: So we had to wait for the yield curve to invert for a full quarter. That happened on June 30. That was a couple of weeks ago. And, I guess, Cardiff, you just procrastinated until now.
GARCIA: Yeah. I've been...
VANEK SMITH: You were just, like, waiting to make sure it really locked in.
GARCIA: I've been collecting those questions, baby.
VANEK SMITH: Collecting those questions.
GARCIA: Oh, yeah.
VANEK SMITH: So the yield curve has been inverted throughout the whole second quarter and a couple of weeks. Specifically, the three-month Treasury has been paying a higher interest rate than the five-year Treasury.
RAFIEYAN: Oh, so some economist, like, ensconced in his ivory tower just chose a calendar quarter, like, out of his hat. Isn't that, like, kind of arbitrary?
GARCIA: Finance scholar, but, yeah.
VANEK SMITH: I feel like this is an excellent point that sarcastic Darius is making. Cardiff, do you have a response?
GARCIA: Yeah. It is kind of arbitrary. But the reason to wait for the yield curve to be inverted for three months is that if the yield curve only inverts for a few hours or for a few days, that does not signal that a recession is coming. The inversion has to last. Again, we are following Campbell Harvey's research here. He chose three months of inversion to study, so we are following that as a guide.
RAFIEYAN: So you are now saying that there is definitely going to be a recession in the next year? I can quote you on this, right? There's a recession coming?
VANEK SMITH: Wow. OK, well, this is - this got real really fast. OK, maybe not.
Actually, so here is something that you might not know. From the time the yield curve first inverts, it has taken an average of slightly more than 12 months for the recession to actually begin. That was the average for the last seven recessions. And for the past recession, the really big one that ended a decade ago, the yield curve actually first inverted 23 months earlier - almost two years earlier.
This time, it could be sooner. It could be longer. Or maybe it will not happen at all. But the point is that the recession usually doesn't start right away.
RAFIEYAN: So you're saying you can't identify a relationship between the yield curve and a recession, so isn't it possible that your magical recession predictor is actually just a series of coincidences?
GARCIA: Again, yes. I don't like your 'tude, but you've got a good point. It's definitely possible...
VANEK SMITH: (Laughter).
GARCIA: ...That it's all just a big coincidence. Remember, the idea here is not that the yield curve causes a recession. The theory is that the yield curve reflects what investors from around the world think about the U.S. economy - the investors who buy U.S. Treasurys.
VANEK SMITH: And the same ones who probably helped fake the moon landing.
GARCIA: (Laughter) Where's this going?
VANEK SMITH: Anyway (laughter) sorry. OK, so U.S. Treasurys are the safest financial asset you can buy. They are what you buy if you think the economy is not going to do well, if you just want a safe place to keep your money because you know the U.S. government is good for the interest payments that it promises.
GARCIA: But when everyone wants to buy Treasurys at the same time, then the government doesn't need to offer a high interest rate on Treasurys for people to buy them, so those long-term rates go down.
And here's the important point. The reason that long-term rates can fall even below short-term rates is that investors are rushing to lock in the long-term rates that are available right this moment because if they waited and the economy got worse, the rates would be even lower in the future.
VANEK SMITH: But that is just a theory. And just because it's held true for the past six decades and seven recessions does not mean that it can't be untrue in the future. Someday, the yield curve might invert, and we might not see a recession for years. That could happen.
RAFIEYAN: OK, so now you're saying the yield curve might be wrong, but you're not even going to tell me why it might be wrong?
VANEK SMITH: Yes, that's right.
GARCIA: The show's over. Thank you.
VANEK SMITH: Just take our word for it. That's all you need to know.
So, OK, Darius, there are a few possible reasons why the inverted yield curve might not actually be signaling a recession this time, why this time might be different. So first of all, the Federal Reserve, the country's central bank, bought a ton of long-term Treasurys as part of its attempt to stimulate the economy after the great financial crisis, the Great Recession. So that could actually be distorting the shape of the yield curve right now because the Fed represents an additional buyer of Treasurys. It could be throwing off the system.
GARCIA: And another possibility is simply that policymakers are aware that an inverted yield curve has predicted the last seven recessions, and so they might change how they manage the economy in response. For example, some members of the Federal Reserve, which manages interest rates, have even brought up the yield curve inversion as a reason to at least be worried about where the economy is headed. So if policymakers are more responsive to the signal being sent by the inverted yield curve, they might avoid the recession by stimulating the economy more.
So, yes, the yield curve's signal for a recession could turn out to be wrong.
VANEK SMITH: Could be the exception that proves the rule.
GARCIA: Sarcastic Darius and sassy Stacey could have a point.
VANEK SMITH: (Laughter).
GARCIA: Part of what makes the yield curve so fascinating is that very mystery, right? We've called the yield curve a kind of crowdsource crystal ball for the U.S. economy. And it has an astonishing track record, but that doesn't make it infallible. You should still be watching other indicators. And for that, I've got a podcast to recommend.
VANEK SMITH: What podcast - THE INDICATOR?
GARCIA: I was actually going to leave it as, like, a - as a blank. Like, if you end it...
RAFIEYAN: Solid plug - shameless.
VANEK SMITH: It's true. That is a little shameless. I kind of like it (laughter).
GARCIA: This episode of THE INDICATOR was fact-checked and produced by Emily Lang. THE INDICATOR is a production of NPR.
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