Traders often look at the bond market
for clues on how the U.S. economy will perform. Specifically the yield curve. Given the yield curve inversion We inverted back in March Yes, we now have an inversion Even if the yield curve inversion
happens again and happens persistently The president tweeting up
crazy inverted yield curve So what is the yield curve all about? And why is everybody
talking about it? The yield curve is just a
graph showing the relationship between short term and long term
interest rates of U.S. Treasury notes. Usually the short term rate
is lower than the long term one. But if you are lending money
to the federal government, which is essentially what happens when you buy a
Treasury note, you are taking a bigger risk by letting the government have
your money for a longer period of time. So you're going to want
a higher interest rate to compensate you for taking on that risk. But sometimes this relationship changes if
the two rates start getting closer together that's called
a flattening yield curve. If the long term rate dips below the
short term rate, that's what we call an inverted yield curve. And the market is concerned about it. Investors waking up this morning to
a recession warning from the bond markets The Dow plunging more than 800
points, sparked by a key economic indicator faltering A brutal day on Wall Street. Stocks plunging as a yield curve
inverted, sparking fears that a recession could be on its way The yield curves predictive power has
made it a crucial metric for investors and policymakers alike. The reason why we watch the yield curve
so closely is that it has been an incredibly accurate predictor
of recessions. Every time that that yield curve
has inverted, the economy eventually has gone into a recession. You can see that predictive
power on this chart. It shows a difference between the long
term ten year and short term three month treasury rates. When that line goes below zero,
it represents an inversion and those inversions have preceded
every single U.S. recession going back 50 years. But it wasn't until the 1980s
when policymakers started to catch on. Back in the late 80s, the yield curve
was being referred to as a possible leading indicator of the economy and I
was asked by my bosses whether there was anything to this whether
you could prove statistically that there was a relationship. Arturo Estrella is one of the
economists who helped discover the predictive power of the yield curve while
working with a colleague at the Federal Reserve Bank of New York. By early 1989, we were not only
seeing the predictive power in general using historical data, but we
actually saw an inversion. So at that point, it seemed to
be indicating that there would be a recession about a year later. And our presentations were met with a
lot of skepticism, but the recession started in 1990. So it was almost
the perfect prediction. Many still doubted the
yield curve, predictive power. But Estrella's model then successfully
predicted the recession in 2001 before the dot com bubble burst. The worst day ever on Wall Street. All the major indices are
now down for the year. And perhaps most notably, after a
2006 yield curve inversion, his model accurately predicted the 2007 downturn
that became the Great Recession. Lehman here is going bankrupt. Some of the biggest names in
American business are tonight gone, along with a lot of money
and a lot of jobs. Estrella's work focused on the difference
between the three month and 10 year interest rates. But many in the finance world also
watch the difference between the 2 year and 10 year rates closely. The New York Fed research focused
on a three month ten year. They feel that that has
the most predictive power. I think a lot of the Wall Street guys
that you talk to will tell you that they don't start to get excited about it
until a 2 year and a 10 year inverts. The broad principles are
pretty similar between both metrics. But to get a clearer idea of how
they work we can imagine traffic on an interstate. Think of 2 and 10 year bonds
like car and truck lanes on a highway. Normally, when the 2 year rate
is lower than the 10 year, traffic is moving along smoothly. Cars in the two year lane are
moving faster than trucks in the tenure. But the Fed raises its benchmark rate
if they think things are going too fast in the left lane. Imagine the Fed like the
sheriff, enforcing the speed limit. Raising rates puts a damper on the
economy, slowing down those in the fast lane. The short term interest rate is
more closely tied to the Federal Reserve funds rate, and it's more connected
to how the economy is expected to perform in the short run. The long term interest
rate is usually higher. Investors are usually paid more to lend
for a longer period of time. As the economy grows you need the money
lend out to be worth more when you get it back. But the long term outlook
for the economy may not be changing much. Those trucks chugging along may
even speed up a little. Well, you know what happens when the
truck's in the right lane are going faster than the cars
in the left lane. That's the inversion we
talked about earlier. And there's a good
chance there's traffic ahead. It becomes more expensive to borrow for
the short run than in the long run. All of this affects how people
lend and the risks they're willing to take that can help drive a recession. The unconventional traffic pattern may get
people to start changing lanes, adding to the complexity
and eventual traffic. It's important to note that the
recessions don't happen immediately after the inversion, but it does mean the
clock is ticking, especially when it comes to the three month ten year
curves that Estrella has done so much work on. The big predictive power is for
about a year ahead, maybe a year to a year and a half. Another caveat is that quick little
inversions in the yield curve lasting for a day, a week or even up
to a month are considered exceptions to the rule. Instead, it's prolonged month-to-month
inversions that suggest a recession is actually coming. It's also important to keep in mind
that even a brief yield curve inversion can spook the markets. The fact of the matter is that we
don't have the kind of markets that we used to have. We don't have markets where
it's a personal touch to it that we have individual investors
out there doing things. Sometimes it's just yield curve inversion
can get fed into the electronic trading systems and it can just
trigger really fast knee jerk reactions. A lot of this is programmed
trading, just computerized trading, especially when you have markets to trade on thin
volume it doesn't take a whole lot to move them. And when something that
has the predictive power of an inverted yield curve comes along, it can
be very influential in a highly sensitive market. So let's say, the
yield curve has actually inverted. What happens between that moment and
the theoretical recession that the inversion is predicting? Well, a back and forth tends
to emerge for market watchers. And the inversion in 2019 offered a
good example with one camp essentially saying this time it's different. It's always kind of a
scary thing to say. This time is different, but I'm
going to say it too. The yield curve inversion I would
not read too much into. There's no likelihood that the inversion
of the yield curve that's occurring in this period a is similar
to the ones that occurred in the prior period, or b that it
will lead to a recession. And another camp heating
the curves warnings. I've been getting this pushback that
it's essentially the yield curve is inverted because global means and no. So, you know, it's it's
not that good an indicator. I would actually argue it is a very
good indicator because we just find it very hard to see how global growth
can be this week and the U.S. can be this one island
of of essentially prosperity. I think we're up toward 40 percent
of recession risk within the next 12 months. And that's a large part in
reflecting what the yield curve is telling us. Amongst the curves detractors some
wondered if the very act of watching the curve so closely had
undermined its worth as an economic indicator. Historically, we had not been
following the yield curve as closely as we follow it now. There's something called the
Heisenberg Uncertainty Principle. Something that's being observed is going
to act differently then when it's not being observed. Others pointed
to negative sovereign interest rates abroad. You have 20 percent more
sovereigns yielding negatively than you had just a few months ago. So there's this drive for yield, attributing
the inversion to a spike in demand for long term U.S. treasuries as money fled those
negative rates in other countries. Trade adviser Peter Navarro comes out and
says it's just it's just a reflection of the fact that
everybody wants our debt. Questions also emerged over whether
Federal Reserve policy since 2008 played a role. I think the Fed still
has a large balance sheet and that could be putting some downward pressure
on those longer term rates. So I'll keep watching
that carefully for sure. But I don't yet see the signal that
suggest it's time to get worried about a downturn or whether the
trade war had contributed. I think what's happening is the trade
tensions are catching up with the market. And I think people
realize it's slowing global growth. And this uncertainty does raise the risk
of recession to its highest level since the 2008 debacle. And I think that's really
what's going on here. Amidst this back and forth. Something interesting happened. The yield curve suddenly un-inverted. Does that mean the recession fears
were overblown and the naysayers were right? Not necessarily. Whenever the yield curve un-inverts or
re-steepens, people tend to be happier or more optimistic. If an inversion is a negative
sign than necessarily an un-inversion would be a positive sign. And
that may make intuitive sense. But what you'll see is if you look
at a graph of inversions and recessions lagging thereafter, the yield curve
typically un-inverts even before a recession begins. You'll have this
inversion with short term rates exceeding long term rates, and then it's
not uncommon to see that correct itself, even in the span between
the initial inversion and the recession. In other words, this re steepening has
proven part of the yield curve's normal predictive behavior. So the inversion is really just
the beginning of the recession warning. But the curve can do all sorts
of things as the recession it predicts comes about, at least historically. But looking ahead, the economy's
immense complexity could easily surprise experts with deviations
from this pattern. It is one indicator. It has been a very good indicator. Is it going to
be a foolproof indicator? Only time is going to
be able to tell that.
