Recession warning signal is flashing; investors carry on

NEW YORK—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.

How can so many along Wall Street feel so confident saying what have been famous last words for so many market trends: This time is different?

Taylor said the curve is “flattening for different reasons.”

When an economic expansion is several years old and the unemployment rate is low, as it is now, short-term rates are usually moving higher as a result of the Federal Reserve hiking its overnight interest rate.

This year, the Fed has raised short-term rates three times, after doing so just twice in the prior 10 years combined. In response, 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 have not followed suit. The Fed has less control over longer-term rates, such as the 10-year Treasury yield, which are affected not only by forecasts for the Fed’s rate decisions but also by expectations for inflation, economic growth and other things.

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.

One big reason for longerrates being stuck in place is stubbornly low inflation. Raises for workers are a bit healthier than in prior years, and wage growth has historically fed through to higher inflation. But the wage gains are still only modest: about 3.4 percent, according to the Federal Reserve Bank of Atlanta. It was closer to 4 percent before the Great Recession and 5 percent at the turn of the millennium.

Another factor keeping 10-year Treasurys low is all the buying coming from overseas, said Erin Browne, head of asset allocation at UBS Asset Management.