Some investors believe that a recession warning that has been flashing on Wall Street for the past several 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 suggesting last year that the economy was headed for a slump. But since then the stock market has rallied and the economy has remained resilient.
The yield curve describes the line that is created on a chart when the rates on government bonds of different maturities are lined up in chronological order. Typically, investors expect to be paid more interest for lending for longer periods of time, creating an upward sloping curve. For the past year, the curve has inverted, with shorter-term yields rising higher than yields on bonds with longer maturities.
The inversion suggests that investors expect interest rates over time will fall from their current high level. And that usually only happens when the economy needs propping up and the Fed decides to help by lowering interest rates.
However, the U.S. economy, while slowing, remains on firm footing and investors are primed for good news from Tuesday’s inflation report, which is expected to show the Fed’s attempts to slow the pace of rising prices are taking hold.
“This time around I am inclined to deemphasize 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 battled runaway inflation, resulting in a recession.
The precise time between inversion and recession is difficult to predict from the yield curve, and has varied considerably in the past. Still, for five decades it has been a fairly reliable indicator.
But 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.”