The bond market is still flashing a warning signal that an economic recession is imminent.The 10-year and 3-month yield curve has been inverted for 212 straight trading days, a record.While fewer economists expect a recession, the economy is still poised to suffer from the lagged effects of the Fed’s rate hikes.
A bond market signal that has been flashing red for months suggests that an economic recession could still be on the horizon.
The 10-year and 3-month yield curve has been inverted for 212 straight trading days, a record that just surpassed the 1980 inversion and is now the longest stretch since at least 1962, according to data from Bloomberg.
The yield curve inverts when short-dated Treasurys offer a higher yield than longer-term Treasurys, a market anomaly that typically suggests a period of economic weakness is imminent.
Part of the expected weakness is based on the fact that banks, which make money by borrowing at typically low short-term rates and lending it out to businesses at higher long-term rates, have little incentive to lend when short-term interest rates are so high.
Another takeaway of yield curve inversions is the idea that the Federal Reserve is likely to soon cut interest rates below the neutral level in a bid to stimulate the economy. But the current inversion is unique in that it’s being driven by a Fed that is focused on taming inflation amid a period of solid economic growth.
That has called into question whether the latest inversion could be the first one on record that fails to predict a recession, especially if the Fed is able to declare victory on inflation and cut interest rates to levels that are still above the neutral rate of around 2.5%.
According to market veteran Ed Yardeni, such an outcome would be “nirvana.”
“It’s conceivable that the interpretation of what the yield curve is saying here is that the Fed managed to succeed in bringing inflation down. The economy has proven to be remarkably resilient and the Fed may not have to raise rates much higher,” Yardeni said in a July interview.
That could mean that the yield curve could uninvert without a recession materializing, as more economists expect. Goldman Sachs said earlier this month that it sees just a 15% chance of the US economy falling into a recession.
But there is still a lingering risk that investors have to confront: the Fed’s aggressive interest rate hikes have a lagged effect on the economy. That means that even if the Fed stops hiking rates for the rest of the year, the ramifications of its more than 10 increases could still work their way through the economy in a negative way into next year.
Prior yield curve inversions have lasted as long as 18 months before a recession hit the economy, like in 1980. And when the yield curve inverted in July of 2006, a downturn in the economy didn’t happen until 15 months later in December 2007.
So while the ongoing resilience in the economy has sowed doubt in the reliability of the yield curve inversion signal, the economy is not out of the woods yet.