The chart that predicts recessions


A crisis of confidence. Automobile production dropped 37 and a half percent. Wall Street reacted very badly. If you were looking at a very specific type of line. You see, normally, this line points slightly
upward — like here, in September 1977. But about a year later, it started pointing
the other way, just slightly! And then not long after that… Boom. The 1980 recession. It happened again a few months later. The line curved downward. Then, boom, another recession. And it happened again in 1988. Again in 2000. And again in the mid-2000s. This line is called the “yield curve.” And that’s why some experts freaked out
when this happened … “A recession warning.” “Inverted yield curve.” “An inverted yield curve.” “Inverted yield curve.” So. What the hell is this line? It all starts with a US treasury bond. A bond is basically an agreement saying: If
you lend the federal government, say, a hundred dollars…
… they’ll pay you interest while they hold onto your money
… until the date they agreed to pay you back. And the longer you let the government keep
your money, the higher the interest rate. So you get more money. Next you need to understand that most people
don’t buy bonds from the government. They buy and sell them from each other, in
the secondary market. And the prices change, based on how much demand
there is for a bond. This basically means that the amount of profit
you can make on each bond changes every day. Trace these bars on any given day, and you
get a curved line, showing the yields of different bonds — or what people call “the yield curve.” And normally, it points upward. Now here’s where it gets even more complicated. Let’s say you’re an investor…
and you have a hunch that an economic downturn is coming, in the near future. If your hunch is correct, that means that
if you buy a two-year bond, you might get your money back in a bad economy,
and there might not be anything good to re-invest in. That makes a two-year bond a lot less attractive
to you. And if lots of other people think this way,
then the demand for two-year bonds plummets. So they start selling for cheaper. But because the two-year bond now costs less,
it yields a better return, relative to that low cost. And at the same time, investors who think
a downturn is coming might think, I’d rather invest in a 10-year bond that pays out way
later — when I think the economic downturn will be over. So that bond gets more popular. But it also gets more expensive. So investors start yielding less money. And if enough investors are acting on this
expectation, the yield on a long-term bond, which is almost always higher than on a short-term
bond, can actually dip lower. And if you draw that yield curve…
… you can see it goes in the other direction. It inverts. In other words, when this chart looks like
this, it means investors think an economic downturn is probably coming in the near future. And that’s what’s happening now. So, is a recession coming? Not necessarily. But when re-design the chart so we can see
all the years on a single screen… … it’s pretty safe to say: When the yield
curve inverts… it’s not a good sign.

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