The bond market is starting to get worried about a recession again

KEY POINTS

• The yield curve, or the spread between bonds of various maturities, is tightening again, with the gap between the three-month and 10-year Treasury notes less than 5 basis points Wednesday.
• When the three-month tops the benchmark 10-year yield, that's called an inverted yield curve and has been a strong sign since 1950 that a recession is coming in the next 12 months.
• The curve inverted last May but then reverted in October, seemingly allaying worries that the longest expansion in U.S. history was nearing a close.

Traders work on the floor of the New York Stock Exchange.

Spencer Platt | Getty Images

Though it has looked like last year's recession scare was a false alarm, the bond market is close to sending another signal about a downturn.

The yield curve, or the spread between bonds of various maturities, is tightening again, with the gap between the three-month and 10-year Treasury notes less than 5 basis points Wednesday.

When the three-month tops the benchmark 10-year yield, that's called an inverted yield curve and has been a strong sign since 1950 that a recession is coming in the next 12 months.

The curve inverted last May but then reverted in October, seemingly allaying worries that the longest expansion in U.S. history was nearing a close. The curve briefly inverted Tuesday morning.

The New York Fed tracks the relationship and establishes a probability based on the spread. As 2019 ended, the recession chance stood at 23.6%, still elevated but a far cry from the nearly 40% reading as the curve inverted.

Fed officials, who conclude their two-day policy meeting Wednesday, may again have to grapple with the prospects of a slowing economy, if the bond market is right about prospects ahead.

"While the Fed may want to portray its 2020 rate policy as stable, markets are signaling that their bias should be to further easing," Nicholas Colas, co-founder of DataTrek Research, said in his daily note Wednesday.

The Fed was not expected to make any rate moves this week. Chairman Jerome Powell has said it would take a "material reassessment" of current conditions to get the central bank to ease further, after 2019's "mid-cycle adjustment" that saw three cuts.

Rising spreads of speculative-grade corporate debt compared to government bonds of the same duration are another cause for Fed concern, Colas said. Also, stocks have rallied as the Fed has expanded its balance sheet since October, putting more pressure on policymakers to keep policy accommodative.

"While the coronavirus has captured the market's attention over the last week Fed policy will return to the fore [Wednesday] and it will be an awkward transition," Colas said. "There's not much the Federal Reserve can say; they are in the same boat as investors when it comes to evaluating what will happen next."