Gloomy outlook for the economy. Photo-Illustration: Intelligencer; Photos: Getty ImagesThank you for reading this post, don't forget to subscribe!
You don’t really need to know much about the economy or the bond market to know that’s a sign that investors live in fear more than anything else. This is called an inverted yield curve – meaning a kind of fluctuation in the relationship between long-term and short-term US government bonds. Under normal circumstances, longer-term bonds – let’s say, a 10-year bond – pay a higher interest rate (aka yield) than shorter-term bonds, like a two-year. When a reversal occurs, that relationship changes, so the 10-year temporarily pays a lower rate than the two-year. (The relationship between the yields on all Treasuries from the one-month note to the 30-year bond constitutes the yield curve.) This phenomenon defies easy logic, but it predicted every consecutive recession for more than half a century. Is.
Unfortunately, all of this is very relevant to the health of the economy today: The yield curve inverted about a year ago, and it remains inverted. While some recession watchers have recently begun to declare the coast clear – even predicting that the indicator will fail this time – others say that the shape of the curve has been changing recently, and They are more worried than ever. To understand this high-stakes puzzle, we turned to the definitive expert on yield-curve inversion: Campbell Harvey, a finance professor at Duke University, who originally discovered the pattern in 1986. I talked to Harvey about what the current inversion means, whether there’s any reason to think things might be different this time — and how he almost made a guest appearance in the Sam Bankman-Fried trial.
Can I ask you to explain the importance of an inverted yield curve, as if you were talking to your niece or nephew or your mother-in-law?
So the yield curve is simply the difference between the long-term interest rate and the short-term rate. Think of a ten-year Treasury bond as the long-term rate and a three-month Treasury bill as the short-term rate. So in the normal yield curve, which we see almost all the time, long rates are higher than short rates. This makes sense because there is some risk in locking your money for a long period. But on some rare occasions, it gets reversed, and you get short rates much higher than long rates – this is unusual, and is called an inverted yield curve and suggests A problem in the economy. And during the last eight recessions, from the late 1960s to today, every time we had a bond market boom where the long-term rate was lower than the short-term rate, the recession occurred without any false signals – so in the last eight. From. And so it’s probably the most reliable indicator of what will happen in the economy.
And is this usually because the Fed is raising rates?
So the yield curve can invert in many different ways. And given that there are only eight examples, you can’t learn much from each one. But I would say that the current inversion is what I consider to be the most dangerous type of inversion, where short rates and long rates both rise, but short rates rise more than long rates. Let me tell you why. When the yield curve inverts, it is bad for banks because the bank business model is that they pay short-term rates to depositors and then they receive interest from their long-term loans. So as the yield curve inverts, it hurts their profitability, where they are paying more and getting the same or less. Hence reversals, regardless of their composition, hurt banks’ profitability.
But the particular type of reversal that we have seen, where long rates also rise, hurts not only profitability but also the balance sheet. So these banks have these long-term obligations on their balance sheets like loans and mortgages or bonds, and as these long rates go up, their value goes down. That’s exactly what happened with Silicon Valley Bank, where their government-bond portfolio had to be written down and that left them with negative equity and they went out of business. So it’s, like, not good.
The yield curve has been inverted for some time, and at first you thought it might be a bad sign. How has your thinking on that evolved?
Yes, so the yield curve inverted in November 2022. On January 4, I wrote a LinkedIn post saying this might be a bad sign, and I had some credibility in saying this, given that this is my model. But there was one very important caveat. I had said, Yes, I think we can avoid a recession, but only if the Fed stops raising rates., And that didn’t happen. I still believe that if the Fed had stopped its rate hikes in January, we could have avoided a recession. But given that the Fed has continued to do so, all this has really done is turn things around.
And I think raising rates so high has been counterproductive. They cite inflation as the reason, but this is a false story. I believe the real rate of inflation right now is more than 1.5 percent. Therefore you cannot make excuse of inflation. The Fed has gone too far. It’s too late for them to realize that they need to stop or reverse course. This is technically called overshooting.
Now there’s an interesting phenomenon with yield-curve inversion, which is that it’s starting to disintegrate – meaning, go back to normal shape. In your model, what is its significance?
So the average time from recession to recession over the last four years is 13 months. So we are not even at the average yet – it is too early to say that this is a bad sign. But more importantly, you look at the last four recessions, and each time, before the recession started, you see a reversal happen or whatever the term is. A decline occurs before the beginning of a recession. So it’s exactly what you would expect.
Yes, a “bear dip”, as people call it when the long end of the curve rises and ends up upside down. If this is happening now, when do you expect a recession?
I hope for the first quarter or second quarter of next year. It’s going to be very interesting because the third quarter GDP is going to be very impressive, and people will think, Oh, okay, that must be a wrong sign. But this growth is driven particularly by consumers drawing down their savings, COVID-era savings, and that savings will dry up in the fourth quarter. Plus the resumption of student-loan payments affects 40 million Americans, and it’s all being taken away from disposable income. Many forces are suggesting that the consumer will not be able to revive the economy in 2024.
So how worried are you? How bad do you think this time can get?
This is very important: I hope my model is wrong. I certainly hope this is a false sign, although I don’t believe it is, and to me a good scenario is a mild recession, something like we had in 2001 or 1990. And ’91.
It’s important for people to remember that even though the 2020 recession was much smaller — because we had the pandemic and we had all the aid then — the yield-curve inversion also predicted it.
Be careful here. And some people say, well, sure, the yield curve didn’t predict COVID. But in real time, when the reversal happened in 2019, there was a lot of other data that suggested a recession was going to happen in 2020. So we will never know. There’s kind of an asterisk on this because of COVID, but again, we may be facing a recession anyway.
Does the severity of the reversal predict the severity of the recession at all?
No, but there is a very strong relationship between periods of inversions and periods of recession. And it depends on when we turn around, but it indicates that the recession could last about nine months to a year. So this is clearly longer than Covid but shorter than the global financial crisis.
You haven’t received any false signals yet. But is there any reason to think this time is different?
Every time is different. And this time there are a lot of differences. One difference is the additional demand for labour. So it’s kind of unique, and I think that’s important because I think it will soften the blow. That excess demand is waning, and it could go the other way very quickly. But still, I think it’s something different.
You mentioned that yield-curve inversion hurts banks, and we’ve already seen some small- to medium-sized banks fail. Do you think some of the big banks are at risk?
Given further hikes by the Fed, banks are not in as good a position as they were a year ago. This is really punitive and disappointing for the banks because the Fed has taken the banks to a scenario that is far beyond the adverse scenario they would have met for their stress test. This is a bit unfair. So I think the financial system is in danger right now. Here’s something interesting that the media hasn’t picked up on that I’m disappointed by: Did you know, you can get 5.2 percent or something like that in a money-market fund? Most people don’t do this. They have a savings account, and the average savings rate across all banks in the US is about 0.5,, So it’s kind of dramatic – you can get ten times more in a money-market fund than what you’re getting from your bank. But this is not the whole story. Too-big-to-fail banks are paying only .01% to .05% on savings. The difference between what they are paying at savings and what you can reasonably get from another vehicle is a red flag to me. And that tells me that the financial system is at greater risk than people think.
We have also seen in recent jobs data that the economy is continuously adding jobs. And it seems some economists – at the Fed and elsewhere – won’t be happy until we have more unemployment. What do you think?
Unemployment is a lagging indicator. Therefore you need to be careful. It’s always a low before a recession, and we’re not there yet. We are in strong growth.
You’re best known for your work on yield-curve inversion, but you’ve also written a book on DeFi and follow crypto quite closely. Are you following the regulatory landscape and what’s happening in the Sam Bankman-Fried trial?
Yes, I was actually asked to be the expert in Sam Bankman-Fried’s defense. So I refused him. But I am following very closely. I think they wanted me to give an opinion on the whole exchange thing and be available to teach the jury and judge about some of the nuances of this area. And again, this is not decentralized finance. That is centralized finance. He was running a centralized exchange and committing fraud by sending customers’ money to hedge funds. Apart from trading some decentralized tokens, it had nothing to do with DeFi.
What is your outlook for crypto in the US now?
I think the big growth area is with regular companies using this technology. So I am very positive.
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