Treasury Yield Curve Inversion Predicts Recession : The Indicator from Planet Money It wouldn't be favorites week at The Indicator without the yield curve. Meet it again for the first time in this classic from the first time Cardiff brought it to the show.
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Indicator Favs: The Recession Predictor

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Indicator Favs: The Recession Predictor

Indicator Favs: The Recession Predictor

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UNIDENTIFIED PERSON, BYLINE: NPR.

(SOUNDBITE OF DROP ELECTRIC'S "WAKING UP TO THE FIRE")

CARDIFF GARCIA, HOST:

Hey, everyone. This is THE INDICATOR FROM PLANET MONEY. I'm Cardiff Garcia.

STACEY VANEK SMITH, HOST:

And I am Stacey Vanek Smith. Cardiff Garcia, you are leaving us at THE INDICATOR.

GARCIA: Stop telling everyone that. It's too sad.

SMITH: It's the truth, though. But listen. It's been three really amazing years. I feel so lucky to have worked with you.

GARCIA: Same.

SMITH: And before you left, we wanted to take this week and just look back at our years of collaboration.

GARCIA: Yes. This week we are diving into the archives for our own personal favorites. And, Stacey, this is another one of your picks.

SMITH: Yes. And, in fact, this was one of our very first shows. It was in the second week of THE INDICATOR. However, this particular episode, it has echoed through our time together.

GARCIA: Oh, yeah. I've definitely gotten more emails about this topic from listeners than literally anything else. It's kind of not close, too.

SMITH: It is about the yield curve.

(LAUGHTER)

GARCIA: Yeah.

SMITH: And almost as soon as we started the show - I mean, we'd only been working together for like a month at this point.

GARCIA: Yeah.

SMITH: I would hear you like waxing poetic about the yield curve. And I'd sort of vaguely heard about the yield curve before, but to be honest, like, I didn't really even know what it was. And so I tried to sort of sneakily read about it so I could like figure out what you were talking about. And I just got confused. So I just decided to, like, put my ego aside and just ask you to explain it to me as part of a show.

GARCIA: It was super fun. This episode originally aired in January of 2018, and it was called The Recession Predictor.

SMITH: But I have always thought of it as why Cardiff loves the yield curve.

(SOUNDBITE OF ARCHIVED NPR BROADCAST)

GARCIA: There's a warning sign for the economy with an amazing track record. And the last five times it flashed, the economy went into recession within about a year.

SMITH: Not only that - but this warning sign, this economic crystal ball - it is the result of trillions of dollars of bets that people all around the world are making every day.

GARCIA: It's not flashing yet, but it's close enough that it will probably make you at least a little bit nervous.

SMITH: Be afraid. Be very afraid.

(SOUNDBITE OF MUSIC)

GARCIA: Today's indicator is the yield curve. That's the economic crystal ball that has predicted the past five recessions in the U.S. And I got to say, it is one of my favorite indicators.

SMITH: Cardiff, you love the yield curve.

GARCIA: Very much.

SMITH: Every time we talk about the yield curve, you kind of light up. And I have no idea why this is the case.

(LAUGHTER)

GARCIA: Yeah. The yield curve. Two words. First word - yield. Let's explain it.

SMITH: That is not an exciting word. In fact, of all the traffic words, I think yield is the most boring of all traffic signals.

GARCIA: I love it. But in this case, when we're talking about yields, we're just talking about interest rates and specifically the interest rates on U.S. government debt.

SMITH: Yeah. So the U.S. government borrows money by selling treasuries. And that is just another word for government debt.

GARCIA: There are different kinds of treasuries. Some of them the government promises to pay back pretty soon - in six months or two years. Some of them the government says, we're not going to pay you back for a long time - 10 years or even 30 years.

SMITH: And, usually, treasuries where the government pays you back over a long period of time - 10 years or 30 years - those will give you a higher interest rate, a higher yield. Treasuries where the government promises to pay you back sooner - six months or two years - those usually have a lower interest rate, a lower yield.

GARCIA: So in normal times, a 10-year treasury will have a higher yield than a six-month. And there's a reason for this. When you expect the economy to grow a lot well into the future, you're going to invest more of your money in the economy itself, like maybe in the stock market or in real estate. You're not going to give it to the government unless, if the government really wants your money, it can offer you a higher interest rate, something high enough to attract your attention.

SMITH: The same thing applies if you expect a lot of inflation because if the price of the stuff you buy is going up, you want to get paid an extra interest rate that keeps up with that.

GARCIA: So OK. That's the yield part, Stacey.

SMITH: OK. All right.

GARCIA: Now we've got to talk about the curve part.

SMITH: I'm hoping that this is really what clinches it.

GARCIA: (Laughter).

SMITH: Go ahead.

GARCIA: Well, we have to visualize it.

SMITH: OK (laughter).

GARCIA: So try to imagine this on a chart. And along the bottom, the chart shows all those different treasuries - six months, two years, 10 years...

SMITH: OK.

GARCIA: ...Thirty years.

SMITH: OK.

GARCIA: And then running up and down on the chart is the interest rate you get for those different treasuries. So the further to the right you go, the higher the interest rate.

SMITH: OK.

GARCIA: When you connect all these dots, you get a line that slopes up and to the right. That line is the yield curve. Boom.

SMITH: Boom.

GARCIA: (Laughter).

SMITH: OK. Explain the boom. I'm not feeling the boom. But maybe I will.

GARCIA: So that's what the yield curve usually looks like.

SMITH: OK.

GARCIA: But not always. And this is where we get to the predicting recessions part. So if you think the economy is going to do badly in the future, then you're not going to invest in the stock market. You're not going to invest in real estate. Instead, you'll be desperate to buy treasuries because at least you know the government is a safe bet to pay you back your money. But that also means the government doesn't need to offer you a very good yield or a very high interest rate to attract your money.

SMITH: OK. So if people who normally buy treasuries are worried enough, then long-term interest rates will fall below short-term interest rates.

GARCIA: That's right. And when that happens, the yield curve flips upside down. So if, say, two-year treasuries are paying 2 percent, and 10-year treasuries are only paying 1.5 percent, the curve is no longer sloping up. Now it's sloping down. Economists call this an inverted yield curve.

SMITH: Inverted yield curve. This is the big recession predictor.

GARCIA: Yes.

SMITH: OK. But why is this such a big deal? I don't understand. Why is it so important that the yield you get for a long-term treasury is less than the yield you get for a short-term treasury?

GARCIA: Because it means that your projection for how the economy is going to do in the future is so bad that you expect short-term interest rates to just keep falling. And so you choose to lock in that longer-term interest rate instead.

SMITH: OK.

GARCIA: And to talk about why the yield curve is such a good predictor and also to talk about what it's telling us now, I called Diane Coyle. She's an economist at the University of Manchester. But more importantly for our purposes, she's like me. She just loves the yield curve.

SMITH: That's wonderful. (Laughter) That's wonderful that you found her.

GARCIA: There's one other person out there who loves the yield curve.

SMITH: Yeah.

DIANE COYLE: The yield curve is one of the best single indicators - I would say the best single indicator - of whether or not we can expect an economic slowdown. And in the United States, whenever the yield curve has inverted since 1970, it has indeed been followed by an economic slowdown, recession. So it's a kind of perfect indicator of when you're going to get a recession.

GARCIA: That's right. Every time the yield curve is inverted since 1970, a recession followed within about a year.

SMITH: OK. This is seeming - I mean, I have to say, in fairness, this is starting to seem kind of...

GARCIA: Are you on the yield curve train, Stacey?

SMITH: Well, OK. A little bit nail-bitey (ph).

GARCIA: There's room for you, by the way. There's room for...

SMITH: (Laughter) There's a lot of room on the yield curve train.

GARCIA: The yield curve train has a lot of vacant seats.

SMITH: (Laughter). OK. Well, the thing I really want to know right now is, are we in inverted yield curve moment right now in the U.S.?

GARCIA: And we're going to tell you.

SMITH: Oh, not right now.

GARCIA: But first, I want to point out something else that Diane says which is really great.

SMITH: OK. All right.

GARCIA: Because part of the reason that the yield curve is such a powerful predictor is that it reflects the views of an astonishing number and range of people and institutions. So there's more than $14 trillion of treasury debt that the public owns right now. And almost half of the investors who own them are from outside the United States.

COYLE: Investors from all over the world buy these assets. And they combine an amazing amount of information about how things have behaved in the past, what their views are about the future.

GARCIA: It sounds like what you're saying is that the yield curve is like a crystal ball, but it's crowdsourced to the whole world.

COYLE: That's a great way of putting it. And forecasts are better when they do combine lots of different, diverse sources of information and people who've got different perspectives on things and different expectations.

GARCIA: And as somebody who follows the yield curve so closely, what do you think it's telling us now?

COYLE: It has recently got flatter. So in other words, the gap between short-term rates and long-term ones is not as big as it as it was a while ago.

SMITH: OK. So flatter...

GARCIA: Yes.

SMITH: ...Than it used to be. That sounds bad.

GARCIA: Flatter than it used to be because short-term rates have gone up, and long-term rates have stayed about the same. But it hasn't actually inverted yet.

SMITH: Yet? That does not sound good. Are we in trouble? Is that what's happening?

GARCIA: Way too early to say. It could steepen again. It might never invert. Who knows? I can also say that people like Fed Chair Janet Yellen have made the argument that the yield curve doesn't communicate the same information that it used to, that maybe the world has changed for reasons that are honestly kind of mysterious. But...

SMITH: This has been the most accurate recession predictor, and it's not looking so good? That's what you're telling me?

GARCIA: Let me put it this way. It's possible that if the yield curve does invert again, the economy this time will avoid a recession. But betting on that also means betting that one of the most impressive forecasting streaks in all of economics will be broken. I'm not sure that's a bet I'd be willing to take.

SMITH: Whose side are you on, Cardiff? (Laughter).

GARCIA: I'm not. I would definitely be voting for the yield curve to break down. But what I'm really hoping for is that the yield curve just doesn't invert, that it starts to steepen again.

SMITH: OK.

GARCIA: That would be wonderful. It means everything's both back to normal and going swell.

SMITH: And that the yield curve remains intact.

GARCIA: Exactly.

SMITH: OK.

This rerun was produced by Alexi Horowitz-Ghazi and originally by Sally Helm and Nick Fountain. It was edited by Jolie Myers and is a production of NPR.

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