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Yield curve recession signals get a new reading

Yield curves are again signaling a possible recession as soon as next year depending on which data are being analyzed, economists say. But new findings from the Federal Reserve Bank of San Francisco — and the behavior of investors themselves — suggest that betting on a slowdown in the next several quarters would be premature.

Since the 1970s, economic models have shown that when the term spread inverts — that is, when short-term yields are greater than long-term yields — a recession soon follows.

Analysts and economists have traditionally focused on the two-year and 10-year term spread, which narrowed to a new low of 18 basis points last week before ticking up to 22 basis points at the end of August, according to the St. Louis Federal Reserve.

This flattening prompted St. Louis Fed President James Bullard to caution, in a recent speech, that if the central bank follows through with its projected rate increases, the nominal yield curve will invert in late 2018.

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However, a better indicator for investors to watch is the 3-month to 10-year term spread, economists from the San Francisco Fed said in a recent research paper.

"Although this particular spread has narrowed recently like most other measures, it is still a comfortable distance from a yield curve inversion," economists Michael Bauer and Thomas Mertens wrote in the paper.

That finding would appear to give investors quite a bit of breathing room — and the Federal Reserve more room to raise rates, Aditya Bhave, global economist at Bank of America Merrill Lynch, said in an interview.

"You can hike a lot more in the coming quarters without inverting the 3-month/10-year term than you would need to avoid inverting the 2-year/10 year," Bhave said.

At its June meeting, when the Fed hiked its federal funds rate to its current range of between 1.75% and 2.00%, the central bank said 2.9% was where it expected the rate to be headed in the longer run. If there are two more rate hikes in 2018, markets might expect at least two more in 2019 to get to that point.

Investor fears

Flattening yield curves also may suggest that investors are anticipating a recession, rather than that a contraction is imminent, Bhave said.

Investors, he explained, are worried that rates are heading higher, so "the long end [of the curve] is lower than the front end." Bond yields go down when prices go up, so more investors seeking safe havens would depress yields.

In addition, concerns about emerging markets such as Turkey and Argentina, and the risk of global trade wars, could likewise send investors flocking to the longer-term assets, Bhave said in a recent note.

"In our view, market-friendly resolutions of [these] issues could push the 10-year yield back up to 3% and possibly beyond," the note said, thus alleviating inversion fears.

Investors also should consider that from the 1978 recession on, there was, on average, a 21-month lag between a yield curve inversion and the start of a recession, said Kristina Hooper, chief global markets strategist for Invesco, in an interview.

Investors should not be adjusting their portfolios immediately based on the yield curve, but rather should be focused on economic data, she said.

"We used to have an on and off switch risk on and risk off; now we're starting to see an environment that's risk aware," Hooper said.

Nevertheless, Hooper pointed to information coming out of the Federal Reserve banks around the country indicating that business owners are still focused on the yield curve and are concerned about what it could portend.

"Right now, the economy is very strong and there's nothing to suggest a recession is imminent," she said. "But business owners are paying attention [to the yield curve], and it could inform their capital investments and hiring plans going forward."

Cat Weeks contributed to this article.