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What Just Happened Also Occurred Before The Last 7 U.S. Recessions. Reason To Worry?

Jun 30, 2019
Originally published on July 5, 2019 9:58 am

Signs are pointing to a coming U.S. recession, according to an economic indicator that has preceded every recession over the past five decades.

It is known among economists and Wall Street traders as a "yield curve inversion," and it refers to when long-term interest rates are paying out less than short-term rates.

That curve has been flattening out and sloping down for more than a year, raising worries among some analysts that investors' long-term view of the market is not positive and that an economic downturn is looming.

But on Sunday, an inauspicious milestone was achieved: The yield curve remained inverted for three months, or an entire quarter, which has for half a century been a clear signal that the economy is heading for recession in the next nine to 18 months, according to Campbell Harvey, a Duke University finance professor who spoke to NPR on Sunday. His research in the mid-1980s first linked yield curve inversions to recessions.

"That has been associated with predicting a recession for the last seven recessions," Harvey said. "From the 1960s, this indicator has been reliable in terms of foretelling a recession, and also importantly, it has not given any false signals yet."

In a 1986 dissertation, economist Campbell Harvey identified an economic indicator that would precede the next seven recessions. That indicator is known as "a yield curve inversion."
Courtesy of Campbell Harvey

Still, many economic forecasters do not see a recession on the horizon.

For instance, Randal Quarles, the Federal Reserve's vice chairman for banking supervision, has said that the gap between short- and long-term interest rates does not mean the U.S. is moving toward a recession.

And then there is a sea of bright economic news setting the backdrop for the yield curve inversion hitting its three-month mark: Unemployment is at a near historic low. The stock market is going strong. The S&P 500 is up 17% for the year. And while some economists say the pace of growth may be slowing, the consensus view is that a dramatic economic plunge is not on the horizon.

But Harvey says no single economic predictor has the impressively prescient track record of the yield curve inversion.

"Yes, the economy looks good right now," Harvey said. "But the yield curve is about the future. It captures the expectations of the broad market in terms of what might happen in the future."

Might a whole quarter of an inverted yield curve become a self-fulfilling prophecy?

"Perhaps," Harvey said.

Consumers could see the data point as a red flag and pull back on spending, or corporations may view the sloping yield curve and decide not to make investments or hire new employees.

"I look at it more in terms of risk management. This is an important piece of information. It helps people plan," Harvey said. "It enhances the possibility that we have a soft landing, not a hard landing, like a global financial crisis."

If the idea of an inverted yield curve remains hard to grasp, Harvey says think of it this way: A yield curve is the difference between a short-term cash instrument, like a three-month government bill, compared to a long-term one, such as a 30-year government bond. When the short-term ones are paying out more than the longer-term ones, something is wrong. And economists call it an inverted yield curve.

Or, Harvey said, think of a certificate of deposit at a bank, better known as a CD.

"If you lock your money up for five years, you expect to get a higher rate than, say, locking it up for six months," he said.

"But in certain rare situations, things get backwards and it turns out the long-term interest rate is lower than the short-term rate, and that's called an inverted yield curve. That's exactly the situation we've got now, and it is a harbinger of bad news."

Copyright 2019 NPR. To see more, visit https://www.npr.org.

MICHEL MARTIN, HOST:

We'd like to talk about the economy now. With a campaign for the upcoming presidential election already underway, you can expect the state of the economy to get a lot of attention. And one of the tools economists use to predict whether a recession is coming is the yield curve, so we want to tell you what that is and why it matters.

We've called Campbell Harvey for that. He's a professor of finance at the Fuqua School of Business at Duke University, and he was the first to demonstrate that the yield curve can predict a recession. Professor Harvey also says he only considers the indicator definitive if the inverted yield curve lasts for an entire quarter. And, well, the quarter ends today, so here to give us his thoughts about what's to come is professor Campbell Harvey.

Welcome. Thank you so much for joining us.

CAMPBELL HARVEY: Great to be on the show.

MARTIN: All right. So let's get the headline, and then we'll work backwards. Are we going into a recession?

HARVEY: The yield curve has inverted for a full quarter, and that has been associated with predicting a recession for the last seven recessions. So from 1960s, this indicator has been reliable in terms of foretelling a recession. And also, importantly, it has not given any false signals yet.

MARTIN: So that would mean yes (laughter).

HARVEY: That means yes.

MARTIN: OK. So let me break down - let me ask you to break down what that means. What is the yield curve, and what does it mean when it's inverted?

HARVEY: So the yield curve represents interest rates at different maturities. So usually, it's the case that a longer-term interest rate has a higher rate than a short-term interest rate. So think of a certificate of deposit at your bank. If you lock your money up for five years, you expect to get a higher rate than, let's say, locking it up for six months.

But in certain rare situations, things get backwards, and it turns out that the long-term interest rate is lower than the short-term rate. And that's called an inverted yield curve. That's exactly the situation we've got right now. And it is a harbinger of bad news.

MARTIN: So unemployment is at a 50-year low. The GDP is growing. Does that have an effect on the yield curve?

HARVEY: So what happens to GDP in the first quarter - that is the past. Corporate earnings, whatever they are - that's the past. Unemployment is a classic lagging indicator. So yes, the economy looks good right now, but the yield curve - the beauty of the yield curve is that it's about the future. It reflects the future, and it captures the expectations of the broad market in terms of what might happen in the future.

MARTIN: So before we let you go - and I apologize if this is kind of reductionist, but this is something that journalists are always accused of all the time, so I'm going to ask. Is there any risk of this being a self-fulfilling prophecy? Is there any validity to the idea that if you, you know, believe that a recession is coming that you could actually in some way influence that it will? Is there any validity to that at all? Not that it's going to change our reporting on what - the facts. But I have to ask.

HARVEY: Sure. And it's a great question. When I originally published my research, nobody much noticed the yield curve. But then it got a considerable profile in predicting the global financial crisis. So now it's on the radar screen. My model is not a model that says the yield curve causes a recession. It is a model that says, well, there's information in the yield curve that can help you forecast a recession. But the idea of self-fulfilling prophecy essentially perhaps makes it causal - that people see this red flag. They know its reliability, and they are more cautious.

So think of a company - major expansion, need to borrow money to build a new plant. The yield curve inverts, and they say, well, let's wait. Or a consumer going on a big vacation where you know that you need to borrow on the credit card. Yield curve inverts - well, maybe we should defer that expensive vacation.

So I look at it more in terms of risk management. This is an important piece of information that helps people plan. It helps corporations plan. And if you can be prudent, you avoid the situation where, oh, you go ahead and build that plant, you borrow the money, we go into recession, and you're out of business, and people are laid off. So I believe that this indicator gives people the ability to do prudent risk management and enhances the possibility that we have a soft landing, not a hard landing like the global financial crisis.

MARTIN: That was Campbell Harvey. He is a professor of finance at the Fuqua School of Business at Duke University and a research associate of the National Bureau of Economic Research in Cambridge, Mass. You heard the man.

Professor Harvey, thank you so much for talking to us.

HARVEY: Thank you. Transcript provided by NPR, Copyright NPR.