The bond market may be giving investors a bit too much confidence.
The yield curve, a measure of the difference between long- and short-term rates, is often looked to as a gauge of economic strength. The longer an investor holds a bond, the higher the annual yield tends to be, in order to compensate the investor for potential inflation and for the missed chance to build wealth elsewhere. For this reason, if long-term bond yields fall closer to those of short-term bonds, it can signal less fear about inflation (which often follows growth) and less optimism about other assets — thus reflecting deteriorating confidence in the economy.
Before the last three recessions, the yield curve on the U.S. 2-year Treasury note and 10-year Treasury note inverted, turning negative ahead of the downturn. As the spread between the 2-year and 10-year tumbled on Monday, some investors may find comfort in the fact that the yield curve remains well above zero.
But Bank of America Merrill Lynch has pointed out one big problem with drawing too much confidence from that simple signal.
"Taken at face value, this may suggest recession odds are small. However, we argue this logic is flawed because the curve is structurally steep when the Fed Funds rate is close to zero. When adjusted for the proximity of rates to zero, the curve may already be inverted and therefore might signal a recession," Ruslan Bikbov of BofAML wrote in a Monday research note.
In December, the Federal Reserve raised the federal funds rate for the first time in nearly a decade, hiking from a near-zero level to 25 to 50 basis points. But rates are still at very low levels, and the recent economic concerns have investors wondering whether the Fed will continue to raises rates this year.
As long as the fed funds rate stays below 1 percent, the yield curve is unlikely to invert even in a recession, simply because it would be almost impossible for long-term yields to fall below those extra-low levels, said Deustche Bank's Joseph LaVorgna. In January, the economist noted that one precedent to consider is Japan, which saw its yield curve flatten without inverting before each of its last four recessions.
'We believe there is a high probability that whenever the next US recession occurs, the 10s-fund curve is likely to remain positive, and perhaps significantly so, at least compared to past business cycles," LaVorgna wrote to clients at the end of January.
The 10-year yield fell to a one-year low on Monday amid a sharp market sell-off and dash to safety. However, Larry McDonald of Societe Generale said the worst of the yield plunge may be over for now.
"For the near term, U.S. 10-years are overbought from a trading perspective," McDonald said Monday on CNBC's "Power Lunch." "If you are long interest rate-sensitive investments ... you want to take the money and run here."