Some investors believe that a recession warning that has been flashing on Wall Street for the past year may be sending a false signal — and think instead that the Federal Reserve will be able to tame inflation and still escape a deep downturn.
That, signal called the yield curve, has continued to reverberate in 2023 and is now sending its strongest warning since the early 1980s of a coming downturn. But despite the alarms becoming louder, the stock market has rallied and the economy has remained resilient, prompting some analysts and investors to rethink its predictive power.
On Wednesday, the Consumer Price Index report showed a sharp decline in inflation last month, further buoying investor optimism and pushing stocks higher.
The yield curve charts the difference in rates on government bonds of different maturities. Typically, investors expect to be paid more interest for lending over longer periods, so those rates are generally higher than they are for shorter-term bonds, creating an upward sloping curve. For the past year, the curve has inverted, with the yield on shorter-term debt rising higher than yields on bonds with longer maturities.
The inversion suggests that investors expect interest rates will fall from their current high level. And that usually only happens when the economy needs propping up and the Fed responds by cutting interest rates.
The U.S. economy is slowing but remains on firm footing, even after a substantial increase in interest rates.
“This time around, I am inclined to de-emphasize the yield curve,” said Subadra Rajappa, an interest rate analyst at Société Générale.
One common measure of the yield curve has hovered this year at levels last reached 40 years ago, with the yield on two-year debt roughly 0.9 percentage points 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 battled runaway inflation, resulting in a recession.
The precise time between a yield curve inversion and a recession is difficult to predict, and it has varied considerably in the past. Still, for five decades, it has been a reliable indicator. Arturo Estrella, an early proponent of the yield curve as a forecasting tool, said that inflation tends to fall after a recession has already started, but the rapid pace of rate increases over the past year may have upset the normal order.
“But I still think the recession will happen,” he said this week.
Others say that history might 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 in mostly good shape.
“The situation we are in is very different from normal,” said Bryce Doty, a senior portfolio manager at Sit Investment Associates. “I don’t think it’s predicting a recession. It’s relief that inflation is coming down.”
