Two innovation market indicators

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0:24The economy is in a confusing place. There are some pretty troubling signs, including the most recent collapse of several banks, and also inflation remaining stubbornly high. But then there are things like consumer spending, which continues to be strong. And in uncertain economic times like these, we go back to our bread and butter, economic indicators. And some of the best indicators can be found in one of the biggest financial marketplaces in the world, with countless bets being placed minute by minute by traders scrutinizing every economic data point and every utterance by policymakers. That is the market for US government bonds.

1:03And right now, the signals from the bond market are flashing in a strange, mysterious way. Hello and welcome to Planet Money. I'm Darian Woods. Today on the show, we're going to bring you two episodes of our daily economics podcast, The Indicator, both looking at what these strange signals from the bond market are telling us. We've got a story on a big recession indicator, the yield curve, and a story on how normally safe and secure treasury bonds can turn ugly. After the break, Adrian Ma and I will head off on our explorations of the bond market, starting with the yield curve. Support for this podcast and the following message come from Recorded Future.

1:44Every day, millions of cyber threats compete for attention, but only a few truly matter to your business. As a leading threat intelligence company, Recorded Future cuts through the noise with precision intelligence. That's why top banks and governments trust them. Because security leaders don't just react. They foresee, spotting the signals that others miss and acting before threats become setbacks. Recorded future. Know what matters. Act first. Of all the economic indicators, there is one that has predicted every recession since 1969 with no false positives. That is a remarkable track record of economic doom predicting.

2:24We're talking about the yield curve. The yield curve. That's right. We talk about it a lot on this podcast, and the yield curve is flashing red right now. It's going alert, alert. I call that code red. Campbell Harvey, Duke University economist, you're a longtime guest on The Indicator. We are obsessed with the yield curve on our show. Yeah, but it's unfortunate that I only get called to be on the show in a bad news situation. It's like I'm Dr. Doom. Campbell Harvey is the guy who discovered the yield curve's predictive powers. If you don't know his name, you should. So according to the model, the model says we will have a reception.

3:04We called up Campbell because he's basically Mr. Yield Curve. Yield basically means interest rates. And the yield curve refers to the way that interest rates tend to go up when you lock away your money in government treasury bonds for a long time. Treasury bonds are arguably the most important investment showing how people around the globe are feeling about the U.S. economy, specifically whether they think the economy is going to get better in the future or worse. So almost all the time, the long-term rate is higher than the short-term rate, and we call that a normal yield curve. It's a literal line sloping up, because to get people to invest in longer-term treasury bonds, investors need some incentive, higher interest rates.

3:49But when things are not normal, when there are economic storm clouds on the horizon, investors flock to long-term investments like the 10-year and 20-year treasury bonds. And with this increased demand, the treasuries don't need to offer such a high interest rate. And meanwhile, because the Fed is raising short-term interest rates to battle inflation, that drives up the interest rates on things like three-month treasury bonds. And that's the so-called inverted yield curve, where you've got short-term rates that are higher than long-term rates. That is bad news, according to my research. Campbell looked at when the interest rate on three-month treasuries was higher than the 10-year treasuries.

4:32And he found that when this difference persisted for a full calendar quarter, eventually economic growth would start to plunge and there would be widespread job losses. Well, those criteria have been checked off. The yield curve inverted towards the end of 2022, and it stayed inverted. But? Maybe it's a bit ironic, given that I am the person that discovered the indicator. But I believe there's a real chance of avoiding a recession and for the model to have a false signal. A false signal. That's very curious. And why is that? So there's many reasons. Number one, the employment situation is quite unique.

5:15Yeah. For one thing, today's data shows that there are 1.7 job openings for every unemployed person. And what that means is if you do get laid off, the duration of your unemployment is low. So it's very short unemployment. And then if you look at the nature of the unemployment that makes the headlines, and it's almost all tech layoffs. And the tech sector has had an extraordinary hiring rate over the last three years since COVID. And what they're doing is they're walking back some of that hiring. I mean, layoffs have also been happening in the media and the finance industries, but in the wider economy, layoffs are actually lower than before the pandemic.

6:07Campbell's second reason why the economy might be fine comes from looking back at the last long recession in 2008 and how indebted people were then. Housing caused a lot of trouble in the global financial crisis. The global financial crisis caused a terrible downturn fueled by heavily indebted homeowners. But now Americans have far less debt. And what this means is that there is the ability to withstand a blow to the housing market where housing prices can go down and the median price has dropped somewhat recently. And it's not going to cause the same sort of contagion that it did last time. The final reason Campbell says we shouldn't necessarily freak out right now is that the yield curve might be less predictive because everyone knows to watch out for it now.

7:01It's all over the news. It's on your show. If you tried to tell your investors, well, it was a complete surprise. And I'm sorry that I bet the firm on a major investment. Basically, it would be laughter. How can you say that? Yield curve is inverted. Why did you make this major capital investment that put our firm at risk? In other words, businesses that are watching the yield curve might be more cautious as a result, and they might not overinvest in things like new factories or hiring a bunch of people. It puts the company in a position so that when there is slower growth, they're able to withstand it.

7:43Yeah, so in other words, the yield curve might be so right that it becomes wrong. Put that on a t-shirt. I believe that we could dodge this potential of recession with one giant caveat. The Fed. Yeah, so the Federal Reserve keeps jacking up interest rates to fight inflation. And Campbell worries that the Fed is going too far. And there's a couple reasons for that. First, Campbell sees the battle against inflation as nearly over. That inflation is soon going to be heading down towards normal levels because we've been seeing a slowdown in housing costs. I believe that the Fed has this unique chance of claiming victory on inflation without driving the economy into a deep recession.

8:30And what they need to do is to stop hiking the rates. The other reason why Campbell thinks the Fed should stop raising interest rates is he says it can hurt banks. Campbell sees the Silicon Valley bank collapse and, you know, the other collapses as being this symptom of what happens when the Fed is raising interest rates and you got an inverted yield curve happening at the same time. Anytime the yield curve flattens or inverts, that's really bad news for the banking system. And that's because banks borrow short and lend long. In other words, they take in short-term deposits from everyday people like you and me, and they give us a small interest payment.

9:10The banks then turn around and lend those deposits for long-term investments like mortgages at a higher interest rate. And banks pocket the difference. And that's in normal times. But now banks are having to pay higher interest rates to depositors right at the same time as their long-term investments are losing value. Campbell thinks the Fed should have already stopped raising interest rates. The Fed statement said our banking system is sound and resilient, but I would have felt a lot better if they provided some evidence to support that statement. Of course, economists have a range of views about what the Fed should be doing right now.

9:49But just stepping back, Campbell Harvey is pretty humble about his findings on the yield curve. It's got so much attention, but he is not saying it's the indicator to end all indicators. even though it's been right so many times in the past. A model is a simplification of reality and it's naive to think that this model, even though it's my model, I'm a scientist and I know that any simple model has got its shortfalls and it can't be right forever. Well, I'm really hoping that it is not right this time. Take one for the team, Campbell. Take one for the team.

10:30After the break, Whelan Wong and Patty Hirsch go deeper into the wild bond market.

10:55or an AI specialist to tailor the tone of your market report. You can do all that with the all-new Adobe Acrobat Studio. Learn more at adobe.com slash do that with Acrobat.

11:11The government bond market is not usually a particularly exciting place. I mean, how unexciting? You can imagine the financial markets as a theme park. Yeah, over there you've got the roller coaster with a 250-foot drop. That's the stock market. That bizarre-looking loop-the-loop thingy over there, that's junk bonds. And then there's that little mini railway that runs around the outside of the park with a driver in a funny hat. That is the government bond market. Safe, boring, dependable. If you invest in a U.S. government bond, also known as a treasury security, you are pretty certain to get your money back.

11:51The risk of that not happening is, like, microscopically small. Yeah, which is why the market in U.S. Treasuries is so dull. Well, usually. Over the last few weeks, the Treasury's market has become one of the scariest places on Wall Street. That little kiddie railroad has turned into the screaming corkscrew of horrifying mayhem. I didn't realize you were, like, a whole theme park operator over there. The prices of some government bonds, in fact, a lot of government bonds, have whipsawed in the wake of the collapse of Silicon Valley Bank and the decision by the Federal Reserve to keep increasing interest rates.

12:24In the government bond space, we don't need to normally worry about credit risk. I mean, the U.S. government normally pays its debt. That's Priya Misra. She's head of global rate strategy at TD Securities. Note the word normally there. The U.S. was a little late with its payments a couple of times in 1979, but it did end up coughing up the money. And the message is that if you buy a U.S. government bond, you will. Barring an apocalypse or a runaway fungal infection or something, get your money back. There is no risk. Well, not so fast. It's true that there is virtually no so-called credit risk.

12:59That's the danger you might not get your money back. But that sometimes fools people into thinking there's no risk at all. People thought of government bonds as risk-free. They're anything but risk-free. I mean, they are credit risk-free. You get your money back. But there's always a but, isn't there? Yes, there is, on this corkscrew mayhem, or whatever you called it earlier. Yeah, buying a U.S. government bond is kind of like welcoming a large cat onto your lap. It's nice and warm and cuddly, but let's not forget that the beast possesses razor-sharp teeth and hook-like claws. Handle it wrongly, and you could get badly mauled.

13:33We've talked a lot about the ins and outs of government bonds on past shows. Why? Because they're fascinating. But today, we're going to pull a lot of these points together. And to help us understand how government bonds can be risky, not to mention risky, we asked Priya to find us one issued during COVID. But, I mean, I'm seeing a really old, and this was issued in 2020, it was issued at the heart of the crisis when the Fed had already taken rates down to zero. It's a one and a quarter May 2050 bond. It's hilarious that two years old is old in this world, but that's the way it is with bonds. And as soon as a bond is surpassed by a new issue, it becomes old.

14:14So ageist, the bond market. Yeah, this is a 30-year bond, which means that in May of 2050, the holder will get their money back from the government, pretty much guaranteed, having received 1.25 % in interest every year. That's like money on top of money. And what's more, government bonds are super liquid, which means they're really easy to sell, even quote-unquote old ones like ours. So where's the risk? Well, first risk, as we know, inflation. When that bond was issued three years ago, inflation was running at 1.2 % annually. The bond has a rate of 1.25%, which means that back then it had its nose just above inflation.

14:50Not much, but at least it wasn't losing money. The buyer looked pretty smart. Today, if they were still holding that bond, they're not looking so hot. Inflation is running at 6%. The investment is now losing money in real terms every day. That 1.25 % in interest is being gobbled up by inflation, like a cat devouring a mouse. Meow! With 2020 hindsight, maybe it would have been better to invest in something else. The best investment last year was leaving your money in a money market fund overnight. So as the Fed raised rates, you earned the higher rates. Yeah, and this brings us to the second risk, opportunity cost risk.

15:27People who invest in treasuries may reduce their credit risk, but the cost of that certainty that they're going to get their money back is a low interest rate. A rate that risks getting creamed by other, better investments that also have a low credit risk. Like that money market account that Priya mentioned. This is a kind of fund that invests in super liquid securities like treasuries, but is churning them, selling older assets and buying newer ones all the time. Oh, that endless pursuit of youth again. Yes, but for good reason. Those fresher bonds have had better returns. Money market funds are pretty much as secure as treasuries, pretty much as dependable.

16:03And thanks to that churn, they've lately been a much better moneymaker than our government bond. That's an upset cat. Which brings us to the biggest risk of all when it comes to treasuries, and the one that we've seen roil the market these last few weeks. Interest rate risk. Rates were low back in 2020, about as low as they ever have been. But then came the COVID recovery boom and the runaway inflation, and the Fed's hiking interest rates, a quarter percent, a half percent, three quarters of a percent. Now, 30-year bonds are being sold with interest rates higher than 4%. Our per-wee 1.25 % bond can't compete with that.

16:39I mean, sure, if you buy our government bonds, you're going to get your money back in 27 years. But because the interest rate on it is so much lower than those new bonds, we're going to have to sell it pretty cheap. How cheap, Priya? I do have a Bloomberg terminal in front of me, so I can tell you in a second. But I would imagine like$70 price. Ooh, that sounds pretty painful. And here we are. The bond I was telling you about is a one and a quarter May 50, May 2050 bond. That's trading at$57 price. $57? That cat is furious. Here's the thing, though. Bond traders and investors expect this kind of thing to happen.

17:17When interest rates rise, the price of bonds with lower coupons fall. It's the way of the bond world. What's freaking them out right now is the volatility that we've seen in the market lately. the wild swings in bond prices. There was a lot of volatility last year based on how much the Fed would raise rates. And the volatility this year is in terms of when do they stop, what's that terminal rate, and when do they go the other way. It all comes down to uncertainty about what the Fed might do and what might happen in the economy. As a result, bond prices have been all over the place. One minute they're down because people are ditching them, expecting rates to rise to combat inflation.

17:55The next, they're up as investors who are freaked out about the global economy look for a safe place to park their money. And this is bad news, not just for bond traders, for whom it's been like taking a nervous cat on a roller coaster ride, but for all of us. Priya says volatility in the bond market pervades every part of the economy. Volatility is high. It increases risk aversion. It makes people reluctant to make decisions, companies reluctant to have investment plans go through. Companies don't know how much it's going to cost to borrow, so they don't take out loans. They don't buy equipment.

18:30They don't expand. They don't hire. Individuals can't decide whether to take out a mortgage now or wait until interest rates come down. So they don't buy houses or the things to put in houses. And lenders, well, they're going to charge you more to borrow. If you want a loan today, the bank that might be making you that loan or the investor that's giving you money might be a little more nervous because a recession looks more likely. they might charge you a higher spread over that. This is what Priya and her Wall Street pals call tightening conditions. And it's actually what the Fed wants, although it could do without the chaos.

19:02The Fed wants to cool the economy and to bring inflation back down. Making it more difficult or less palatable to borrow is a step towards that end. These two Indicator episodes were originally produced by Brittany Cronin and Noah Glick. They're fact-checked by Sarah Juarez and engineered by Gilly Moon and Catherine Silver. Kate Conklin edits The Indicator. The Planet Money version was produced by Dylan Sloan and edited by Dave Blanchard. I'm Darian Woods. This is NPR. Thanks for listening.

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