The OG Yield Curve Whisperer : The Indicator from Planet Money A conversation with Campbell Harvey, whose 1986 thesis first explained how the yield curve could predict the direction of the economy.

The OG Yield Curve Whisperer

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Hey, INDICATOR listeners, it's Cardiff. We have done a few episodes now about the yield curve. We've called it the recession predictor. And you might remember that the yield curve just shows the interest rates on different government bonds or Treasurys. And in those rare times when the interest rates on long-term Treasurys like 10-year Treasurys are lower than the interest rates on short-term Treasurys, it means that an economic recession is on the way. And the yield curve has an amazing track record of predicting recessions. But I also find it to be deeply fascinating for all kinds of reasons.

But my co-host Stacey thinks I'm kind of ridiculous for continuing to go back to it, so I'm springing a bit of a surprise on her. I'm about to invite her into the studio to let her know that I have taped yet another interview about the yield curve. And I'm just kind of curious to see how she reacts.


Hi. Hi, Cardiff.

GARCIA: What's going on?

VANEK SMITH: Not much.

GARCIA: Are you a little curious about...

VANEK SMITH: Yes. What's...

GARCIA: ...What I've called you in here for?

VANEK SMITH: Yes, I'm so curious.

GARCIA: Check it out. I've done an interview for an episode of the show.


GARCIA: And it's with the guy who first discovered back in the 1980s that the yield curve could be such a powerful predictor of economic activity (laughter).

VANEK SMITH: Oh, my gosh. You...

GARCIA: That's right. We're running it back.


GARCIA: We're bringing THE INDICATOR back to the yield curve.

VANEK SMITH: Back to the '80s. Well, you know, that's awesome. I think that's awesome. But who was this man with - who had this vision of the yield curve?

GARCIA: That's what today's show's going to be about. By popular demand or at least by my demand, we are going back to the old curve one last time with the person who first formally laid out its predictive powers back in the 1980s.


GARCIA: Oh, hey, here he is, the guy who first explained formally the powers of the yield curve.

CAMPBELL HARVEY: I'm Campbell Harvey. I'm a professor of finance at Duke University. And in 1986, I published a thesis that detailed the predictive ability of the yield curve to forecast U.S. economic growth.

GARCIA: This was the seminal paper on this topic. Am I right?

HARVEY: It is the first paper.

GARCIA: (Laughter).

Back in the 1980s, when Campbell was working on his thesis, he says that other scholars were investigating the stock market to see if it could help predict where the economy was going. And Campbell was not convinced.

HARVEY: So the idea that equities should have information about the future path of economic growth because equities discount future earnings from companies. So it kind of made sense. But when you actually look at the equities, they were delivering a lot of false signals. So the market would drop, but there was no recession. So I was thinking, well, what if we looked at something less risky, something less volatile? And it was logical to look at the bond market.

VANEK SMITH: Specifically, Campbell started looking at the U.S. government bond market. So you might remember from our previous episodes that the yield curve shows the different interest rates that are paid by each of the different U.S. government bonds or Treasurys. Treasurys have different expiration dates. So for example, there is a 3-month Treasury, a 2-year Treasury, a 5-year, a 10-year and so on. That is just when you cash them out after that period of time. And the yield curve just shows you the different interest rates on those different Treasurys.

GARCIA: And the basic idea behind Campbell Harvey's thesis was simple. When the economy is expected to grow, the yield curve should slope up. In other words, as you go from short-term Treasurys to long-term Treasurys, the interest rates should be getting higher and higher. So the interest rate on a 10-year Treasury should be higher than the interest rate on a 5-year Treasury. And that should be higher than the interest rate on a 3-month Treasury.

And the reason this happens is that if the economy's expected to grow, then long-term Treasurys have to pay higher interest rates in order to attract buyers because otherwise buyers can just invest in the economy itself. Like, they can invest in a company or in the stock market. But when longer-term interest rates fall below short-term interest rates, we say that the yield curve has inverted. It is sloping down. And an inverted yield curve is a forecast that an economic recession is on the way.

VANEK SMITH: Allegedly.

GARCIA: Allegedly.

VANEK SMITH: Campbell's thesis looked at all the times since the 1960s that the yield curve had inverted. More specifically, he looked at all the times that a longer-term interest rate had fallen below a short-term interest rate for at least a full quarter, so for at least three months. And what he found was that every single time the yield curve inverted, a recession followed. And every single recession had been preceded by an inverted yield curve. There were no false signals. But Campbell says his thesis was greeted with a bit of suspicion by his fellow academics.

HARVEY: To be frank, some members of my committee were pretty skeptical. They said...

GARCIA: Really?

HARVEY: ...Not enough observations. So you've got only a handful of recessions. How do we know this isn't just lucky?

GARCIA: Campbell's reasoning here, the idea that the Treasury market was more useful for predicting economic growth than the stock market, it would immediately get a useful test because in October 1987 on a famous day known as Black Monday, the stock market started crashing. And a lot of people thought this big fall in the stock market meant that a recession was on the way in 1988. Not Campbell.

HARVEY: I was the lone voice saying, no, there's not going to be a recession in 1988. My model suggests that economic growth will be 4.1 percent. And that was way up there.

GARCIA: The yield curve had not inverted at the time. It was...

HARVEY: Exactly. The yield curve was not inverted in 1987. The economic growth that was realized in 1988 - 4.2 percent. So it was remarkably accurate and basically not doing a false signal.

VANEK SMITH: And ever since, every time the yield curve has inverted for a quarter, a recession has followed usually within about a year. The yield curve right now, by the way, is not inverted. But it has just become a lot flatter recently, so it is getting closer to inverting.

GARCIA: A lot of people have been wondering if the yield curve is no longer quite as useful as it used to be. And when I say a lot of people, I'm including one Stacey Vanek Smith.

VANEK SMITH: OK, OK. I mean - but - yes, but there - I am not alone. There is definitely room for healthy, intellectual skepticism about the yield curve right now.

GARCIA: Absolutely. You are definitely not alone. And the thinking here is this. The Federal Reserve, the U.S. central bank, has been a huge buyer of Treasurys for roughly the last decade. This was all part of the Fed's attempt to stimulate the economy after the big financial crisis.

VANEK SMITH: So essentially, the government has been getting high on its own supply.

GARCIA: And so if the Fed is buying all these Treasurys, then maybe the yield curve has been distorted by all that buying. And so maybe the signals it sends are not as helpful as they used to be.

HARVEY: This idea of distortion of the yield curve is not a new idea. Indeed, the distortion of the yield curve was a lot easier in the 1960s and 1970s when the government bond market was a lot smaller. So throughout the sample that I actually look at, there's been plenty of intervention. So this is just the norm. And to try to make the case that it's somehow different today than it has been in the past I don't think holds a lot of water.

GARCIA: Doesn't hold a lot of water.

VANEK SMITH: Well, I mean, consider the source here, Cardiff. Of course he loves the yield curve and thinks it's great.

GARCIA: And he's been proven right ever since he did.

VANEK SMITH: Ever since, yes. But Campbell does say that using the yield curve to predict a recession is just part of a model. He also expresses some healthy skepticism.


VANEK SMITH: And he also says that all models, you know, can stop being useful if the world changes in some fundamental way. And he says that someday that could happen to his model, too.

GARCIA: Yeah. But for now...

VANEK SMITH: Even the man who discovered the yield curve thinks that, you know, got to have a little bit of skepticism about the yield curve.

GARCIA: A little caution...

VANEK SMITH: A little caution.

GARCIA: ...Never killed anybody.


GARCIA: Or maybe it did. But...

VANEK SMITH: Actually, it probably did.

GARCIA: (Laughter).


GARCIA: But for now Campbell's clear that at the moment the yield curve is not forecasting a recession. It's gotten closer to inverting in the past year, but you need an actual inversion for it to be forecasting an upcoming downturn. And again, the inversion would have to last for at least a quarter. None of that is happening now.


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