A recession warning signal is flashing; investors carry on

One of Wall Street’s traditional warning signs for a recession is flashing yellow, and nobody seems to care. The signal lies within the bond market, where Treasurys maturing in a couple years have been paying nearly as much in interest as bonds that take a decade to mature. The gap between the two is usually much wider. Market watchers call this phenomenon a “flattening yield curve,” and it’s often been a harbinger of slowing economic growth, if not a recession. Earlier this month, a 10-year Treasury was offering just 0.53 percentage points more in yield than a two-year Treasury. The last time the spread was so thin was in October 2007. Two months later, the Great Recession began. “The curve normally is the ultimate crystal ball portending recession,” said Rich Taylor, client portfolio manager at American Century Investments. “It tells us what the economy will do. And a curve this flat would suggest we have an impending recession.” Yet Taylor and most of Wall Street say that technical factors are making the yield curve a less reliable indicator this time around, and they don’t see a recession looming on the horizon, at least not in 2018. Even Federal Reserve chair Janet Yellen echoed the sentiment last week. Why do so many believe this time is different? Taylor said the curve is “flattening for different reasons.” With the economy expanding and unemployment low, the Fed has raised short-term rates three times, after doing so just twice in the prior 10 years combined. The yield on the two-year Treasury has climbed to nearly 1.85 percent, up from from 1.25 percent at the end of 2016. But longer-term interest rates, which the Fed has less control over, have not followed suit. The 10-year Treasury yield is close to where it ended last year, at 2.50 percent compared with 2.47 percent. If the trend continues and short-term rates go higher than long-term rates, it would create what market watchers call an “inverted yield curve.” That would be a flashing red light on the warning system because it can indicate the bond market is expecting weak economic growth. A rule of thumb says a recession would follow in about a year, and an inverted yield curve preceded each of the last seven recessions, according to the Cleveland Fed. By Stan Choe Longer-term rates have been stuck in place for a number of reasons. Modest wage growth in the U.S. hasn’t been enough to spark inflation, which remains stubbornly low. Foreign buyers have jumped into 10-year Treasurys because bonds overseas are paying nearly nothing in interest, and in many cases actually have negative yields. That keeps a lid on rates and in turn makes the U.S. Treasury yield curve flatter than it would otherwise be. “The flattening of the yield curve today is going to have a different impact on growth and corporate health than it has in the past,” Browne said. “We don’t think that even an inversion of the yield curve, while it certainly would make headlines and people would raise eyebrows, would have the same impact in this cycle as it would historically.” Of course, if Wall Street is underestimating the predictive power of the yield curve this time around, it may be a while before investors are able to tell. Economists don’t even say a recession has begun until months after its start.