Yield Curve: You Asked, We Answer
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 the yields curve. Try to contain attain strew 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 treasuries 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 assigned that the country will go into a recession within about a year or two now. If you're a new listener you might not know that I am totally fascinated. Stacey would say obsessed is gonNA say fascinated donated by the yield curve not because it is a perfect all the time constantly occasionally <hes> 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 gonNA continue. Would you say that the yield curve is practically perfect in every way I would not. I'd say that I have been careful not to say that 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're so fascinated by it and today on the indicated from planet money we we are going to answer them. I'm cece panic. Smith Your Sassy Vanik. Smith is what you are and I'm Garcia respond to that those questions our listeners census. We're all really smart but in some cases those questions were also also asked with just as much SAS sarcasm is stacy's giving me right now. There's so much their race yourself guard channel that spirit of inquisitive sarcasm we are going to paraphrase our listeners questions and have them read aloud by producer. Dariz Shari's rob beyond just has a phenomenal sarcastic voice. That's true Jeez. Don't cry about it. That's in an after the break sarcastic questions and our answers support for N._p._R.. And the following message come. I'm from Exxon Mobil. The company that believes affordable scalable carbon capture is critical to reducing industrial C._O.. Two emissions and more and more experts agree learn more at energy factor dot com support also comes from Microsoft snow. Leopards <unk> are very difficult to find researchers use Microsoft A._I.. To analyze thousands of remote camera images in minutes so they can find and study them more efficiently more at Microsoft dot com slash A._i.. Okay for this episode. If you WANNA 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.. Treasuries so there's a three-month treasury a one year treasury 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 and when the economy is expected to do well L. Longer term treasuries should pay higher interest rate than shorter term treasuries 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 five year treasury you have to wait five years to get your money back your money is is locked in the Treasury so you'd expect to be paid higher interest rate than if you only had to wait three months to get your money back but when the economy is not expected to do well the yield curve convert and all that means is it longer term treasury start paying lower interest interest rates then short-term treasuries 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 is inverted over the past six decades a recession session 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? <hes> correct me if I'm wrong but the yield curve inverted way back in March so is there a reason you wait until now to do a show about it. Okay fair point good question APP. Here's the thing the first scholar to discover the link between the inversion of the yield curve and recessions it 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 calendar quarter which means the same quarters of the. Here 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 so we had to wait for the yield curve to invert for a full quarter that happened on June thirtieth that was a couple of weeks ago and I guess card if you just procrastinated until now yeah wait and just make sure those questions navy yes so the yield curve uh spin inverted throughout the whole second quarter and a couple of weeks specifically the three months Treasury has been paying a higher interest rate than the five eight year Treasury. Oh so some economists like inside constant is ivory tower just chose a calendar quarter like out of his hat. Isn't that like kind of arbitrary finance scholar but yeah this is an excellent point. That's artistic. Jerry's is making card. If you have a response yeah it is Kinda arbitrary but the reason to wait for the yield curve to be inverted for three months is that if the yield curve only verts 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're following Campbell Harvey's research here. He chose three months of inversion to study so we are following that as a guy so you are now saying that there is definitely going to be a recession in the next year. I can call you on this right. There's a recession coming. Wow okay well this is this got real really fast. Okay maybe not actually so here's something that you might not know from the time the yield curve I in verse it is taken an average of slightly more than twelve months for the recession to actually begin that was the average for the last seven recessions and for the past recession really big one ended a decade ago deal curve. Actually I inverted twenty three 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 okay so you're saying you can't identify a relationship between the yield curve a recession so isn't impossible that you're magical recession. Predictor is actually just a series of coincidences again yes. I don't like you're tuned but you've got a good point. It's definitely possible. 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 by U._S. Treasuries and the same ones who probably helped fake the moon landing? Here's this going anyway. The sorry okay so U._S.. Treasuries are the safest financial asset you can buy. They are what you buy if you think the economy meat is not going to do well if you just WanNa save place to keep your money because you know the U._S.. Government is good for the interest payments that it promises but when everyone wants to buy treasuries at the same time than the government doesn't need to offer a high interest rate on treasuries 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 it investors are rushing to lock in the long term rates that are available right this moment these if they waited in the economy got worse the rates would be even lower in the future but that is just a theory and just because it 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 okay so now you're saying the yield curve might be wrong but you're not even gonNa tell me why it might be wrong. Yes that's right. The show's over just take our word for it. That's all you need to know so okay Dr. Is there a few possible 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 Central Bank bought eight none of long-term treasuries as part of its attempt to stimulate the economy after the great financial crisis the great recession Russian so that could actually be distorting the shape of the yield curve right now because the Fed represents an additional buyer of treasuries it can be throwing off the system at another possibility is simply that policymakers are aware that an inverted yield curve has predicted the last seven recessions and 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 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 signal for a recession could turn out to be wrong could be the exception improves the rule sarcastic Darius Jason Sassy Stacey could have a point 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.