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Bond market's recession indicator may not be working this time

Key Points
  • The bond market's recession indicator, the Treasury yield curve, continues to reflect a future weakness in the economy, but some analysts say it is not acting as the signal it once did.
  • The yield curve is getting flatter. The market believes a reliable inflation indicator is when it inverts, or shorter duration yields rise above the yield on longer duration debt.
  • One strategist said the Fed's quantitative easing has created distortions that make the so-called "inversion" less meaningful.
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A bond market recession indicator considered to be reliable is sending more and more negative signals about the economy, but some analysts say there's no reason for fear.

The indicator, the so-called yield curve between 2-year Treasury note yields and 10-year note yields, is getting a lot of attention, even from investors who never watch it. That is because the difference between the two yields is getting closer and closer to zero.

The two yields were 30 basis points apart at one point on Tuesday, but the difference has been as close as 28 recently. The spread between the 10-year note yield and 30-year bond yield was even narrower, at 9.9 basis points.

When the yield on the shorter duration security rises above the longer duration security, or inverts, it is seen as a recession warning. An inverted yield curve has proven to be a reliable indicator over the years.

Don't fear the yield curve. Here's why

"Inverted curves have always been lurking at the scene of the crime when there's a recession. It's more of a coincident indicator than a causal factor," said Jim Caron, fixed income portfolio manager and managing director at Morgan Stanley Investment Management.

Caron said this time the yield curve could be signaling the extreme policies the Federal Reserve undertook to drag the economy out of the financial crisis.

"One thing we have to reconcile is what's unique about this environment is we just went through a long period of QE [quantitative easing] to keep rates lower than normally would be the case. Most estimates for QE would argue the curve is probably on the order of about 40 to 50 basis points flatter than it normally would be," he said. "The flatness of the yield curve is instead a weaker signal about a recession than it has been in the past because of all these QE factors."

QE was a program under which the Fed purchased Treasury and mortgage securities over a period of several years to keep rates low. It is now in the process of unwinding that program and raising interest rates, but Caron argues the Fed is not yet at the point where it is "tightening" policy.

In the view of some in the market, the Fed's ability to keep raising interest rates is in doubt because it would push the curve to an inverted position very quickly. Fed interest rate hikes influence the short tend of the curve, and the 2-year yield was at 2.56 percent Tuesday, compared with the 10-year yield at 2.85 percent. The longer end of the curve reflects expectations for economic activity in the future.

"I think it's still a valid barometer but you need to adjust for its weaker signal about the future," said Caron.

In fact, a recent Fed paper argued that the recession warning may not be anything more than the market's expectations about monetary policy.

"When do investors expect monetary policy easing? Presumably, when they anticipate a substantial slowing or decline in economic activity. Consequently, it is not all that surprising that negative readings for the near-term spread tend to precede (and thus can be used statistically to forecast) recessions," Fed officials wrote. "This does not mean that inversions of the near-term spread cause recessions. Rather, the near-term spread merely reflects something that market analysts already track closely — investors' expectations for monetary policy over the next several quarters and, by extension, the economic conditions driving those expectations."

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