Today, Explained - What's up with the yield curve?

Episode Date: August 15, 2019

Vox’s Matthew Yglesias explains why everyone's whispering about a recession. Learn more about your ad choices. Visit podcastchoices.com/adchoices

Thank you. downturn is around the corner. Bank of America says the chance of a recession in the next year is one in three. What do you say, Matthew? Is the recession coming? Matthew Feeney I love one in three is a great coward's call. You can claim you were right either way. No, I mean, unfortunately, there's no really foolproof way to predict recessions. But there's an elevated concern today because there is something that has tended to happen historically before a recession. And it's kind of happening now. You're talking about maybe a clue, a clue of some kind.

A clue, a warning is what we often call it. And it's called the yield curve. Uh-oh. Yeah. It's a yield curve. The yield curve? It's pretty sweet. I see you tweeting about the yield curve. It's a yield curve. The yield curve? It's pretty sweet. I see you tweeting about the yield curve.

People love the yield curve. It's your jam. Yes. So nobody likes to talk about charts, but— Is that what we're about to do? I'm going to try to actually leave it out. Here's the way it works, right? So the government sells lots of different bonds.

They trade in a secondary market. Yes. They have what's called yields, which is like an interest rate. Yes. And normally the long-dated bonds have higher interest rates than the short-dated bonds. Is that like an incentive? It's just because like your money is going to be tied up for a longer period of time. Yeah.

So you normally demand a higher return in order to get that. But what's happened now in the markets is that the long-dated bonds, the 10-year bonds, have a lower yield than the short ones, than the two-year bonds or than the three-month bonds. And how did that happen? Well, I mean, it's just the independent actions of lots of people trading bonds. So it's diffuse, right? There's no guy in a basement somewhere who's like, I want to make trading bonds. So it's diffuse, right? There's no like guy in a basement somewhere who's like, I want to make this invert. But it has happened.

It is unusual. When did it happen? Wednesday morning, we got inversion between the 10-year and the two-year bonds. Just yesterday? Yes, exactly. And this is the yield curve? Yes.

And for the past 35 years, every time the 10-year yield has gone below the two-year yield, there has been a recession. And every recession has been preceded by this kind of inversion. So particularly to the sort of practical trader types, this is like puts their hair on fire. Academic economists are a little less certain about the meaningfulness of all this, but it's clearly, it's a bad sign. Okay. So the interest rates for these longer term bonds, aka the yields, have taken a downturn. They're even looking worse than the short term bonds, which in recent memory has always meant it's recession time. And this is all represented in a chart, a graph.

I'm not scared. Tell me about the yield curve chart. Okay, so what happens is people make a chart. And the chart has on the x-axis, it has a bunch of durations. So three months, six months, one year, two year, five years, like that. And then the y-axis, it has the yields. And then, literally, you draw a curve through them. And normally, it's a curve that starts low and it slopes up and it goes high.

Okay. Three months, six months, one year, two year, five years, five years. Today, it starts—it doesn't even start that high, but it starts low and then it gets lower. Three months, six months, one year, five years. Oh. And so that is an inverted yield curve. Is it even curving? It does.

It just curves downward gently. Okay. Okay. So that's a bad thing. It is a sign of bad things to come. Huh. Is there like a useful metaphor here? Yeah, okay.

So you can imagine like a wine yield curve, right? You say, I've got bottles of wine, it's a great vintage, and they're only going to get better with age. I don't drink wine. Is that actually true? I think so.

That's what the people say? It may be true, yeah. So you would normally expect the bottles to get more expensive with time. Oui, oui. Because the aging makes them nicer and because there's storage costs involved. Parfait.

So five years out, it should be more expensive. Ten years out, it should be even more expensive. Fantastic. But there's other stuff happening in the world. So you could imagine the 10-year wine, its price starts to fall really, really rapidly. Non, non, non. And that's a sign that something is going wrong 10 years in the future.

Because you know the wine is good. Oh, bien sûr. But the price is going to be low. And that could be something weird, like just everybody gives up wine, they all become Mormons, maybe the government bans alcohol. Sacre bleu! But a really plausible explanation would be there's a recession in the future. So even though your wine's really nice, people just, like, they don't have money and they're not able to go buy it.

Merde. Okay, so like a fine wine, the yield curve's always supposed to be growing in value. But obviously, if something bad happens to the wine market, like everyone swears off wine, the market starts to sink. And that's what's happening right now to the yield curve. This interest rate that should be creeping up is instead creeping down. Yeah. So the yield curve inversion, it doesn't necessarily mean a recession is coming. But it means something is anticipated by the financial markets that's not great.

Some kind of future world of very, very low interest rates, which historically what has brought that about has been a recession. So the market's anticipating a recession right now and that's why the yield curve has sort of flipped? That seems to be the case. I mean, again, we're not really sure. There haven't been that many recessions historically. So we don't have like perfect laboratory science about this. But as best we can tell from history, this is the sign that financial markets are anticipating a recession. So are you scared? Yeah, a little scared.

Have you sold things? No, you're not supposed to do that. The problem with panic selling, right, is that everything that I know about this or that you might hear me explain on a podcast, like the guys with the fancy hedge funds and the algorithmic trading and all this stuff, like they also know this stuff. So the current market prices already reflect, you know, my insights about wine and even more than that. So I'm not going to try to like out trade the professional traders, even though I am kind of worried about the situation.

Just practically speaking, what would a recession in this administration in 2019 look like? I mean, last time it wreaked havoc on real estate in the United States, especially, but also a ton of other things, the auto industry. What would it look like right now? So the most recent recession we had was the worst recession in multiple generations. So you would just assume another recession will probably not be that bad. If you remember the recession that happened in 2001, you don't want to say it wasn't bad because a lot of people lost their jobs and it was sad, but it was a little difficult to characterize. Like there was no obvious calamity.

There was a slowdown in home building, a slowdown in purchases of appliances, a slowdown in major business investment, shops closed, people got their hours cut. It was a hard time, but there was no like one big crazy thing. And right now, I mean, as far as I know, as far as anyone knows, we don't have any sort of massive credit vulnerabilities, financial crises, things like that happening. We are talking about a just general slowdown in business activity that's related to a slowdown that's happening all around the world. Well, tonight, the dreaded R-word is looming large over financial markets. Recession. Europe's largest economy could be heading for recession. Stock markets are on edge as tech and oil prices continue to fall.

The bottom line is that after two years of solid expansion, the world economy is growing more slowly than expected and risks are rising. There are problems in almost every major economy around the world. There have been ominous numbers out of Germany, out of China, out of the United Kingdom. Argentina is in a disastrous situation. So there's like a lot of bad stuff happening. Let's start with Germany. What's going on there? So Germany has this very manufacturing-based economy, very oriented toward exports.

In the most recent numbers, their economy shrank by 0.1%. That's not a huge amount, but normally you want an economy to grow. Instead, it's shrinking. And particularly because Germany is so sensitive to global conditions, it's a sign that like people all around the world are buying less stuff. And Germany, obviously, a central figure in the European Union. What about the UK, who's currently trying to leave the European Union? Right. So the UK has also had a yield curve inversion.

There is a lot of concern that they are going to Brexit in an economically destructive kind of way. A broad brush picture from the Treasury of the damage to our economy after we leave the EU. And the grim detail from the Bank of England as house prices crash, inflation soars, and the economy tumbles if we fail to reach a deal. I think there you have sort of the clearest story that businesses in the UK do not want to invest because there's a lot of nervousness about what is coming this fall. What about China? Obviously, this comes at a time when the US and China are at each other's throats on trade. What's going on there? Yeah, so we know all about this

trade war between the United States and China. America has been trying to damage the Chinese economy, and it seems to be working. That's not the only factor there. Their growth model for years, people have been saying, this is going to run out of steam. Their factory output has been falling. It's the lowest it's been in 17 years. So they're having some real problems there. Does recession change the nature of the game in that regard? Is it a lot harder to wage a trade war when the economy is not growing?

I mean, I would hope that some of this would bring leaders together around the world to say that they need to try to make things be better rather than worse. There's a lot going on in Trump versus China. The German government also has its own, I think, harmful ideas about economic stimulus and balanced budgets. One reason that it's hard to know with any of this like yield curve magic is like, is a recession coming? Is that if world leaders get sufficiently alarmed, they might get together, take action, and prevent one. I mean, we talk about Germany, China, the UK, the United States. How bad is it for the rest of the world if these countries fall into recession?

That's really bad. I mean, those are most of the world's top economies. There's no way Japan could avoid a recession if all those other countries were in recession. They do so much exporting of capital equipment, things like that. Then you have developed countries which do a lot of commodity exporting, you know, crops, metals, basic minerals. So they'll be hurt in a global recession. It tends to pull almost everyone down. One of the things that happened in the 2008 recession that was almost miraculous from a global perspective is that China didn't have a recession. You know, well, for America and Europe, that was almost miraculous from a global perspective is that China didn't have a recession.

You know, while for America and Europe, that was terrible, if you kind of take a macro historical view, you'll say that a lot of global development issues actually kept getting better thanks to China there. So if China joins the rich world in a recession, even if the recession is not that bad from our perspective, it would be a real sort of tragedy from a global view. I mean, to bring this back to the yield curve, where we have this sort of telltale sign in the United States that has flipped, that could signal a recession, are there signals internationally that we should be looking towards? And if so, what are they?

Yeah, I mean, the UK is already in a yield curve type situation. There is a different kind a yield curve type situation. There is a different kind of yield curve inversion happening in European bonds. Also something you see in many European countries is that their government bonds actually have negative interest rates, which is a whole different kind of financial market anomaly. But it also suggests a very weak global demand situation. So it doesn't look good. It's not great, no. If world leaders aren't yet coming together to save the world from recession, what are we, the individual people in this economy, to do?

Ah, nothing really. You're just a helpless victim of impersonal global forces. We're just mere pawns. Yes, exactly. You should, you know, buy whatever toothbrushes we're advertising That's getting cut Keep the gears of commerce churning Well, good luck, Matthew

Thank you We'll have you back when there's a recession I'd love to Okay Alright, good luck to everyone. Matthew Iglesias writes about politics and economic policy at Vox.com. His podcast, The Weeds, drops on Tuesdays, but also Fridays. This is Today Explained. We drop every day, but not on the weekends. The show's on Twitter at Today Underscore Explained. Give us a follow, tell a friend, especially if you have friends who don't understand the yield curve.

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