How Cam Harvey Invented The Yield Curve Inversion

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During their latest episode of the VALUE: After Hours Podcast, Harvey, Taylor, and Carlisle discuss How Cam Harvey Invented The Yield Curve Inversion. Here’s an excerpt from the episode:

Campbell: -on the whole idea? It’s hilarious now, but in real time, it wasn’t. So, I’m a first-year master student and I applied for internship in Toronto. That’s where I was in between first year and second year. I go into this company that was called Falconbridge, the world’s largest copper miner in the world at the time. And this is in 1982. I walk in as an intern, first-year master student into the corporate development area and they said, “Well, your job is to design a forecasting model for real GDP.”

Tobias: Easy.

Jake: Oh, yeah, no problem, layup.

Campbell: Yeah, that’s exactly my attitude. Like, “Oh, okay, well, this is normal. This is what I should expect in the world of big business.” I just shrugged it off, figured, “Okay, well, I got to do this.” The competition at the time were these companies that were specialists in these giant econometric models. So, they have massive data systems, hundreds of equations, and then you’d have to pay them tens of thousands of dollars to get one number.

So, I’m thinking I’ve got nine weeks, and there’s just no way I can assemble a model like that or the data. I can’t compete against them. What about using some stuff I learned in the intro finance course, that assets actually have information about the future path of whatever, earnings or things like that. So, I started looking at the stock market, I quickly realized that was just all over the place. And the joke at the time was the stock market predicted successfully, like nine of the last five recessions.

Jake: Right.

Tobias: [laughs]

Campbell: So, a huge false positive rate. But I quickly moved to bonds. It just seemed ideal, because a bond has got a fixed coupon versus a dividend that you have no idea what it’s going to be. A bond has got a fixed time to maturity and a stock, again, who knows what the maturity actually is. And then just on the risk angle, if you’re looking at treasury bonds and bills, those have very low risk compared to stocks, where the value of stocks can fluctuate– Even if the cash flows are the same, if risk goes up, then the stock is going to go down.

So, I decided to look at bonds and then decided to look at a spread and yields, and I wanted to do that to take expected inflation out. There was this early paper that I saw published by somebody at the Federal Reserve, 1965. So, it was way back. They noticed a cyclical pattern. It was nothing to do with forecasting, but they just noticed a cyclical pattern. And I said, “Well, I definitely want to look at the yield curve.” I put this model together. It was shocking to me that I could do as well or better than these econometric services. I’m ready to present to the senior people at Falconbridge. It’s my day of presentation. I go in and I’m told that the whole division is laid off, and [Jake laughs] I need to collect my stuff and be shown the door at the bottom of the building.

So, before I could present it to them– To know what’s going to happen in real GDP is so important for copper. It’s like Dr. Copper. You need to know in terms of your exploration budget, opening a mine, closing a mine, all this stuff, very important. I actually delivered something. Well, I didn’t deliver it. So, I’m gone. I’m on the street and I decide, “Well, this idea is pretty cool. Maybe I’ll just spend the next three or four weeks working on it.” Then I went back. My second-year masters, presented the paper, and they said, “Ah, you need to go for a PhD.” And that’s how I ended up at the University of Chicago. So, that’s the story.

The story is very solid economic foundations. Just think of the simplest possible scenario that, if people get nervous about what’s going to happen in the economy, then there’s a flight to safety. And often that safety is the 10-year bond. Just thinking of that alone. Well, if the 10-year bond, a lot of demand for price goes up, yield goes down, and that serves to flatten the yield curve or even inverted. So, the original model in my dissertation at the University of Chicago, 1986, was based upon expectations that financial assets like bonds and stocks but bonds a lot less noisier contain valuable information about the future.

It’s also the case that in contrast to the, let’s say, the stock market, the economy is a lot easier to forecast. The intuition for that is pretty clear also that things are sticky, that you make an investment that takes a while to actually pay off in the economy. It’s not like a stock investment. You’re buying equipment or a plant or employees. So, there is predictability in the business cycle and you just need to come up with a model for that. My model has been, I would say, I’m trying not to be immodest here, successful.

Jake: [chuckles] So, you knew what you were going to write for your thesis before you even got into grad school?

Campbell: Yeah, this is– [crosstalk]

Jake: That’s pretty wild.

Campbell: I now evaluate these applications.

Jake: Yeah.

Campbell: Again, I didn’t know anything. Back then, PhD, how long is that going to take? I told my parents and they are shaking their head, and they said, “Well-

Jake: “Who’s going to pay for that?”

Campbell: Masters was excessive, given that [Tobias laughs] neither of them had undergrad degrees. “So, what is a PhD? Like, another year?” I said, “I don’t think so, but I don’t really know.” Actually, the first day there, somebody gave me a tour and I asked the person, “Well, how long you’ve been in the program?” because he looked rather ragged-


Campbell: -and a lot older than I expected. He said, “Well, it’s my 9th year.”

Jake: Oh.

Campbell: I said, “You graduating this year?” “I don’t know.”

Jake: And his name was Cliff Asness. [laughs]

Campbell: No. I actually did overlap with Cliff. I came back as a visiting professor. It was actually hilarious because I graduated after three years. Given that I came in with my topic that saves a huge amount of time. A number of years, of coursework, then you start thinking about research. No, the first day, I’m working on my project. So, I was looking for a job after my second year and accept a job after three. And then, I get invited back for a visiting professorship. In the finance seminar, I would just sit with the students in the student area, because I knew them. They’re my colleagues.

Jake: Yeah, your friends.

Campbell: But it was really confusing to the faculty because they thought I was still in the program, “Oh, he’s taking a long time.” But I did overlap with Cliff. He was a brilliant student and actually had the pleasure of reading one of his papers and commenting on it. It was fun to do. At that time, there were so many great students, including Cliff at Chicago.

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