Some investors believe that the recession warning that has flashed on Wall Street for the past few months is wrong and that the Federal Reserve will be able to tame inflation and still escape a deep downturn.
The signal – called the yield curve – began to suggest last year that the economy was headed for a downturn. But since then the stock market has rallied and the economy has remained resilient.
The yield curve describes the line created on a chart when the rates of government bonds of different maturities are lined up in chronological order. Typically, investors expect to be paid more interest for lending over longer periods of time, creating an upward sloping curve. Over the past year, the curve has inverted, with shorter-term yields rising more than yields on bonds with longer maturities.
The inversion suggests that investors expect interest rates to fall from their current high level over time. And that usually only happens when the economy needs a boost and the Fed decides to help by lowering interest rates.
However, the US economy, although slowing, remains on a firm footing and investors are braced for good news from Tuesday’s inflation report, which is expected to show that the Fed’s attempts to slow the pace of rising prices are catching on.
“This time I tend to de-emphasize the yield curve,” said Subadra Rajappa, an interest rate analyst at Société Générale.
One common measure of the yield curve is the most inverted it has been in 40 years, with the yield on two-year debt roughly one percentage point higher than the yield on 10-year notes.
The last time the yield curve was so inverted was in the early 1980s, when the Fed last fought rampant inflation, resulting in a recession.
The exact time between inversion and recession is difficult to predict from the yield curve, and has varied considerably in the past. However, for five decades it was a fairly reliable indicator.
But history may not repeat itself this time because the current conditions are idiosyncratic: The economy is recovering from a pandemic, unemployment is low and companies and consumers are mostly in good shape.
“The situation we’re in is very different from normal,” said Bryce Doty, senior portfolio manager at Sit Investment Associates. “I don’t think it predicts a recession. It’s a relief that inflation is coming down.”