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Yield curve warns of greater recession risk, but bond market signal not perfect

While the latest yield curve inversion signals investors' increasingly pessimistic outlook on the economy, there are reasons to believe it may not be the accurate recession predictor that it was in the past.

Yield curve inversions have historically been followed by recessions several months later, though a downturn has not occurred in every instance. Inversions occur when yields on longer-term Treasury securities fall below those of shorter-term Treasurys, an unusual development given that investors usually demand higher returns for lending to the government for longer periods.

But some economists are questioning whether the yield curve's solid track record of predicting recessions will hold up this time around, pointing to central banks' substantial postcrisis bond holdings as one factor that could be distorting the traditional signal. Negative interest rates in other countries may also be pushing even more foreign investors into U.S. Treasurys, which skeptics say may be further complicating the yield curve's message.

Those questioning the yield curve's current signal include former Federal Reserve Chair Janet Yellen. In an interview with Fox Business set to air Aug. 16, she said the yield curve has historically been a good predictor of recessions but emphasized that "on this occasion, it may be a less-good signal."

"I think the answer is most likely no," Yellen said when asked whether the U.S. was headed into a recession. "I think that the U.S. economy has enough strength to avoid that. But the odds have clearly risen, and they are higher than I'm frankly comfortable with."

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Others are heeding the yield curve's warnings, even as they acknowledge that its signal may be somewhat different today.

"It makes me extremely nervous," said Jim Paulsen, chief investment strategist at The Leuthold Group.

Worries about an inverted yield curve are not entirely new, given that 3-month Treasury yields have already been above 10-year Treasury yields for several weeks this year. But those concerns increased on Aug. 14 when 10-year Treasury yields briefly dipped below 2-year yields.

"To see this one go negative is just more evidence, more data that suggests we're getting closer to the end of the cycle," said Tony Roth, chief investment officer at Wilmington Trust.

The inversion, in large part, reflects investors' fears about the global economic outlook. The U.K. and German economies both contracted in the second quarter, and the prospect of a messy Brexit and a U.S.-China trade war continue to pose risks to growth.

Worries over global growth typically prompt investors to flee to safe-haven securities, such as 10-year U.S. Treasury notes. The increased demand for 10-year Treasurys drives up their price, which lowers their yields since prices and yields vary inversely. Falling 10-year Treasury yields make inversions more likely since their distance from shorter-term yields shrinks.

But the Fed's Treasury holdings, which exceed $2 trillion, are also likely playing a role, according to Wells Fargo acting Chief Economist Jay Bryson. He wrote in a research note that the Fed's bond holdings may be holding down 10-year yields by 25 to 50 basis points, putting the yield curve that much closer to inversion territory.

The yield curve's ability to predict recessions may be less reliable today, he wrote. But mounting uncertainties to the economic outlook pose the risk that market participants could "end up 'talking ourselves' into a recession" even if current economic data remains relatively healthy, he added.

An outlook for muted inflation may also be holding down yields on longer-term Treasurys, with investors requiring less compensation in exchange for risks that inflation will eat away at their earnings, Michelle Meyer, head of U.S. economics at Bank of America Merrill Lynch, wrote in an Aug. 9 note to clients.

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The spread between 3-month Treasury bills and 10-year notes has been inverted for 66 non-consecutive days this year, and the current 37-basis-point difference between the two is significant but not as large as other recent inversions.

Despite their brief inversion, yields on 10-year Treasury notes recovered and are a touch above those of 2-year notes, still pointing to an extremely flat curve, but one that is no longer in negative territory.

During the past five recessions, both of those spreads have usually undergone sustained inversions before a recession hit, though the time the economy took to slip into a downturn varied significantly, Meyer wrote.

"Compared to history, we are still far from getting a strong signal from the bond market that a downturn is around the corner," she wrote.

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