Some investors believe the recession warnings seen on Wall Street over the past year may be giving the wrong signals — and instead they think the Federal Reserve will be able to control inflation and still avoid a deep recession. .
That signal, called the yield curve, has reverberated through 2023 and is now sending the strongest warning of an impending recession since the early 1980s. But even though the alarms are sounding, the stock market has rebounded and the economy remains resilient, prompting some analysts and investors to reconsider its predictive power.
On Wednesday, a Consumer Price Index report showing a sharp drop in inflation last month raised investor optimism and lifted stocks.
The yield curve shows the difference in rates on government bonds of different maturities. Typically, investors expect to pay more interest when lending for longer periods, so these rates are generally higher than for shorter-term bonds, creating an upward-sloping curve. For the past year, the curve has reversed, with yields on shorter-term debt rising more than yields on bonds with longer maturities.
The reversal suggests that investors expect interest rates to fall from their current highs. And that’s usually only when the economy needs to get going and the Fed responds by cutting interest rates.
The US economy is slowing but remains on strength despite a substantial increase in interest rates.
“This time, I am inclined to emphasize the yield curve,” said Subhadra Rajappa, interest rate analyst at Societe Generale.
A common measure of the yield curve has flattened this year to levels 40 years ago, with the yield on two-year debt about 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 was battling runaway inflation, which resulted in a recession.
The exact timing between a yield curve inversion and a recession is difficult to predict, and there is considerable variation. Yet, for five decades, it has been a reliable indicator. Arturo Estrella, an early proponent of the yield curve as a forecasting tool, said inflation tends to decline once a recession begins, but the rapid pace of rate hikes in the past year has upset the normal order.
“But I still think there will be a recession,” he said this week.
Others say history won’t repeat itself this time because the current conditions are peculiar: The economy is recovering from the 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, a senior portfolio manager at Sitt Investment Associates. “I don’t think it is predicting a recession. It is a matter of relief that inflation is coming down.