In this episode of the Enterprising Investor podcast, Cam Harvey looks at his groundbreaking research on the yield curve as an indicator of economic recessions within the context of today’s economy and up to date monetary policy actions. Harvey, a finance professor at Duke University, pioneered the study linking inverted yield curves to looming recessions – a relationship that has proven remarkably reliable over the past 4 many years.
Understanding the yield curve inversion
A standard yield curve slopes upward, meaning that longer-term investments will yield higher returns because of the upper risk and time horizon. An inverted yield curve – where short-term rates of interest exceed long-term rates of interest – signals that investors expect slower economic growth or an imminent recession. This inversion is taken into account a robust leading indicator of economic downturns.
In fact, Harvey’s research has made the yield curve probably the most closely watched tools by economists, investors and policymakers. Its predictive power has stood the test of time and continues to be relevant in several economic environments. In this episode of the EI podcast, Harvey tells the remarkable story of how he developed and tested his original theory.
Current economic context
Harvey looks at the present 20-month yield curve inversion and the impact on the economy. He explains that the curve inverted again in late 2022, sparking widespread concern about an impending recession. Since the Sixties, there have been eight yield curve inversions, each followed by recessions. “This is a very simple indicator that hits eight out of eight with no false signals. The economy is so complex that it’s remarkable that you can have something that works so reliably,” Harvey enthuses. He acknowledges that the return time between inversion and recession is inconsistent, starting from six to 23 months. The current inversion is 20 months.
Monetary policy
Harvey has been critical of the Federal Reserve within the press. In this EI podcast episode, he discusses the Fed’s role in the present yield curve inversion. He claims that the Fed’s aggressive rate hikes to combat inflation contributed to the inversion. While the central bank is raising short-term rates to curb inflation, long-term rates haven’t risen as quickly, resulting in the inversion.
Nuances and considerations
Although the yield curve is a vital forecasting tool, Harvey stresses that it mustn’t be viewed in isolation. He advises that other economic indicators and market conditions ought to be considered when assessing recession risk. For example, aspects equivalent to employment rates, consumer confidence and company profits also play a vital role in understanding the broader economic picture. He shares the info that he believes market participants and policymakers ignore to their detriment.
Harvey also examines the potential consequences of a chronic yield curve inversion. In the past, prolonged inversions have often led to deeper and more severe recessions. He warns that a chronic inversion could portend greater future economic problems. But he also suggests that appropriate policy motion, particularly from the Federal Reserve, could mitigate these risks.
