Some investors believe that the recession warnings that have been flashing on Wall Street over the past few months are wrong and that the Federal Reserve will be able to tame inflation and still escape a deep downturn.
The signals – called the yield curve – started showing last year that the economy was headed for a slump. But since then the stock market has rallied and the economy remains resilient.
The yield curve depicts a line drawn on a chart when the grades of government bonds of different maturities are arranged in chronological order. Typically, investors expect to be paid more interest on loans for longer terms, creating an upward sloping curve. Over the past year, the curve has reversed, with short-term yields rising more than yields on bonds with longer maturities.
A reversal indicates that investors expect interest rates to drop from current highs over time. And that usually only happens when the economy needs propping up and the Fed decides to help by lowering interest rates.
However, the US economy, while slowing, remains on firm footing and investors are bracing for good news from Tuesday's inflation report, which is expected to show the Fed's efforts to slow the pace of price increases are starting to stall.
“This time I tend to de-emphasize the yield curve,” said Subadra Rajappa, interest rates analyst at Société Générale.
One common measure of the yield curve is that it is the most inverted in 40 years, with the two-year debt yield roughly one percentage point higher than the 10-year note yield.
The last time the yield curve was so inverted was in the early 1980s, when the last Fed fought runaway inflation, resulting in a recession.
The exact timing between an inversion and a recession is difficult to predict from the yield curve, and has varied widely in the past. However, over the past five decades it has become a fairly reliable indicator.
But history may not repeat itself this time because conditions are very special right now: The economy is recovering from the pandemic, unemployment is low, and companies and consumers are mostly doing well.
“The situation we're in is very different from what we're used to,” said Bryce Doty, senior portfolio manager at Sit Investment Associates. “I don't think it predicts a recession. It's a relief that inflation is coming down.”