"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."