UNIDENTIFIED PERSON: This is PLANET MONEY from NPR.
CARDIFF GARCIA, HOST:
Hey, listeners. It's Cardiff Garcia here. I'm the co-host of PLANET MONEY's daily show, The Indicator, along with Stacey Vanek Smith. And I'm here to help a PLANET MONEY listener.
LEO SUSSER: My name is Leo Susser. I'm 13, and I'm in seventh grade. I'm wondering about the inverted yield curve because it just inverted, and, like, I'm worried that there could be another recession.
GARCIA: OK. Well, listen; as it happens, Leo, PLANET MONEY has a spinoff podcast called The Indicator. Have you ever listened to it?
LEO: I've heard of it.
GARCIA: We have actually done a bunch of episodes about the yield curve already. So I'm going to make you a deal. I'm going to send you episodes of The Indicator to listen to. And then after the show, I'm going to give you a call and see what you think. Does that sound good?
LEO: OK, yeah.
GARCIA: This is a great topic to be asking about right now. And actually, Leo is not the only one. A lot of people have been emailing PLANET MONEY to ask what is up with the yield curve. And does it mean we're about to have a recession?
Now as you'll hear, my co-host Stacey Vanek Smith can vouch for the fact that I am kind of obsessed with the yield curve. I find it fascinating. I find it mysterious. And I'm amazed by the fact that for the past six decades, when the yield curve inverts, it has anticipated every single recession. So today, we are putting together our two favorite Indicator episodes about the yield curve, and we're going to dedicate them to Leo.
Hello, and welcome to PLANET MONEY I'm Cardiff Garcia. Today on the show, the yield curve - what it is, what it means when it inverts, what it means that it does invert, an interview with the guy who discovered the inverted yield curve as a recession predictor, and finally, our answer to the question of whether you should be scared and nervous and panicking when you see those headlines about the yield curve inverting - you shouldn't, by the way, real quick, short answer.
OK, 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.
STACEY VANEK SMITH, HOST:
Specifically, Campbell started looking at the U.S. government bond market. 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 three-month Treasury, a two-year Treasury, a five-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 five-year Treasury. And that should be higher than the interest rate on a three-month Treasury.
And the reason this happens is that if the economy is 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.
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.
HARVEY: They said 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 the economic growth will be 4.1%, and that was way out 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%. 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.
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 (laughter).
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: 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, you got to have a little bit of skepticism about the yield curve.
GARCIA: A little caution...
VANEK SMITH: Little caution...
GARCIA: ...Never killed anyone.
VANEK SMITH: ...Yeah.
GARCIA: Or maybe it did.
VANEK SMITH: Actually, it probably did.
GARCIA: We're going to take a quick break. And after, we're going to answer the question of what's been happening with the yield curve lately, right now in 2019.
(SOUNDBITE OF MUSIC)
GARCIA: OK, so we put together this next episode of The Indicator in July of this year because back in March, something happened that we had been saying could happen ever since we launched The Indicator - the yield curve inverted. And since March, it has stayed inverted. Campbell Harvey's flashing warning sign, the full quarter of this upside-down world, has, in fact, happened. So this next episode, one that we sent to our listener Leo, addresses some of the questions you had about the yield curve.
(SOUNDBITE OF ARCHIVED NPR BROADCAST)
VANEK SMITH: The yield curve.
GARCIA: Try to contain your excitement.
VANEK SMITH: (Laughter) It's true. 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: I was going to say fascinated. OK, sure.
GARCIA: Wouldn't necessarily be wrong...
VANEK SMITH: We'll go with fascinated.
GARCIA: ...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: (Laughter) I don't even know how to respond to that.
GARCIA: (Laughter) 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 is 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: Like, jeez, Cardiff, don't cry about it.
GARCIA: That's him. So, 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've waited until now to do a show about it?
GARCIA: OK, fair point.
VANEK SMITH: Oh, good question.
GARCIA: Snap. 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 just to make sure it really...
GARCIA: ...I've been collecting those questions, baby.
VANEK SMITH: Collecting the 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's 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 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 (ph), but you've got a good point. It's definitely possible 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: Where is 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 (laughter).
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 crowdsourced 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 gone to leave it as like a - as a blank. Like, if you end it...
RAFIEYAN: Jeez, solid plug. Shameless.
VANEK SMITH: It's true. That is a little shameless. I kind of like it (laughter).
GARCIA: We always love your questions at PLANET MONEY, so please email firstname.lastname@example.org. There's also Facebook, Twitter, Instagram. We're @planetmoney on all of those.
These Indicator episodes were originally produced by Darius Rafieyan and Emily Lang, with Paddy Hirsch as editor. Darian Woods and Cynthia Betubiza produced this version. Alex Goldmark is PLANET MONEY's supervising producer. And Bryant Urstadt edits the show.
VANEK SMITH: I'm Stacey Vanek Smith.
GARCIA: And I'm Cardiff Garcia. This is NPR. Thanks for listening.
(SOUNDBITE OF MUSIC)
GARCIA: I called up our listener Leo afterwards and asked him what he thought of these episodes.
LEO: Yeah, I found them really fascinating.
LEO: I like how you, like, talked about both sides on how it might not be realistic.
GARCIA: And how do you feel about the economy now having heard these episodes about the yield curve?
LEO: I'm less sure that it actually predicts the recessions.
GARCIA: Yeah, it might not. You're not as worried about the economy now.
LEO: Yeah, not as.
GARCIA: Not as worried, still a little bit worried, yeah.
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