A Classic Recession Warning is Being Ignored


The inverted yield curve that normally precedes a recession has some investors nervous, but most are ignoring it.

The market’s most-popular recession warning is flashing red again as fears about the economic impact of China’s coronavirus outbreak prompt a big drop in Treasury yields.

Yet the warning—a drop in the 10-year Treasury yield below the three-month bill, known as an inverted yield curve is signaling something much more benign: the expectation of Federal Reserve support later this year.

The 10-year yield has fallen below the three-month bill yield ahead of every recession since the 1960s. In fact only two times the inverted yield curve didn't ring the recession bell, in 1966 and briefly in 1998.

The yield curve is more likely to miss the next recession anyway, because the Fed rates are already so close to zero. 

The inversion which began last week looks more like the 1998 exception than it does the correct warnings, however. Prerecession yield curve inversions in the past occurred because investors believed that interest rates were momentarily too high as the Fed attempted to regulate the economy and reduce inflation.

Unlike prior recession warnings, the 30-year Treasury yield is still well above bill yields. Federal-funds futures are pricing in at least one rate cut, and close to a 50% chance of two or more cuts this year. The difference is that the three-month yield has not reflected these cuts, but longer-term yields do, so long-run yields are below the three-month yield.

Rather than pricing in a recession, investors are pricing in slower growth partially offset by cheaper money.

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Economics, Finance and Investing