U.S. long-term interest rates saw a sharp drop in recent weeks, reigniting fears about a potential yield curve inversion and whether that would signal the approach of a recession.
But some analysts are downplaying the recent flattening of the yield curve, saying they see few signs of an economic downturn in 2019 even if the chances are a bit higher in 2020. They are also questioning whether the recession indicator has lost some of its predictive power, given the effects of the massive interventions central banks undertook to fight off the financial crisis.
"If you look at the economic data we see a clear story: We will not have a recession anytime soon," Torsten Slok, chief international economist at Deutsche Bank Securities, wrote this month. He highlighted continued job growth and a healthy outlook for both consumers and small businesses as some examples of positive figures.
Others are more pessimistic, saying that global growth is expected to dip down, trade tensions have not yet abated, and the U.S. housing market is showing some signs of weakness. Lindsey Piegza, chief economist at Stifel, said the yield curve's recent flattening "simply compounds the justification" for the Federal Reserve to slow down on its planned rate hikes in 2019.
"With data slowing, and the risk of recession on the rise, it will now prove increasingly difficult to justify more aggressive action," she wrote.
An inversion in the yield curve, where shorter-term bond yields rise above those of longer-term ones, has historically preceded recessions, and a debate over whether a flatter curve is sending warning signals has played out for much of the year.
The curve has gotten narrower in recent weeks, just as the Federal Reserve was preparing for its final meeting of 2018, where the central bank is expected to raise its benchmark federal funds rate for a fourth time this year.
Some portions of the yield curve inverted this month, but that has not happened in the spread analysts watch closely: the spread between 10-year U.S. Treasurys and 2-year ones. The spread between the two was roughly 20 basis points as of Dec. 14, significantly narrower than the 60-basis-point spread at the start of 2018.
Yields for 10-year sovereign debt have also fallen in the 14 other largest economies in the world over the past month, with Brazil seeing the largest decrease at 71 basis points.
It remains unclear whether most Fed officials would be overly concerned that their next few rate hikes could invert the yield curve, given that shorter-term yields are more responsive to the Fed's rate increases.
Fed Chairman Jerome Powell said in September the yield curve is one of many indicators the Fed considers when making its monetary policy decisions and that the odds of a recession remained low. But a handful of other Fed officials have said the central bank should avoid testing out whether this time is different.
The debate over the yield curve's predictive power has in part centered on the quantitative easing programs that the Fed and other central banks undertook during the crisis. Their large-scale asset purchases, some economists and Fed officials say, have held down yields for longer-term bonds and are therefore distorting the yield curve's signals.
Ethan Harris, global economist at Bank of America Merrill Lynch, wrote that the indicator's track record "has created an ugly feedback loop" among investors in recent weeks. But he pointed to a recent Richmond Fed paper that said term premiums — the compensation that investors get for holding onto long-term assets — look to be significantly lower today. If the term premium narrows, the authors argued, yield curve inversions "will become more likely even if there is no increased risk of recession."
Harris wrote that investors should not ignore the yield curve but that he expects some of the political risks currently roiling markets, such as trade tensions between the U.S. and China and the potential of a messy Brexit, will "reach a relatively benign resolution" and lead to an easing of financial conditions.
"The markets are justifiably worried about ongoing policy shocks and a potential hit to U.S. and global growth," he wrote. "But the slope of the curve is just one of many signals from the markets to the economy."