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