And Then There Were Two (Inverted Yield-Curve Recession Signals)

One of the crowd’s favorite yield curve pairings (the spread on 10-year less 3-month Treasuries) has been signaling elevated US recession risk since May. As of yesterday (Aug. 14), the 10-year/2-year spread has gone over to the dark side too. That alone doesn’t insure that economic output will slump in the near term, but it’s a clear message that the crowd has increased its collective bet that a US downturn is approaching.

It’s all about the market’s probability estimates rather than fate. But if you’re inclined to consider yield curves’ implied economic forecasts, the sight of two widely followed spreads in below-zero terrain is worrisome. As outlined by The Capital Spectator recently, history suggests that recession warnings are more compelling when both the 10-year/3-month and 10-year/2-year spreads are flashing red.

Despite the stronger signals for expecting an economic downturn, some analysts aren’t drinking the Kool-Aid, at least not yet. Viktor Shvets, head of Asian strategy for Macquarie Commodities and Global Markets, for instance, remains skeptical that the economy has crossed the macro Rubicon. “My view has always been that yield curve predicts absolutely nothing,” he tells CNBC. “What it does tell you (is) that you will have a recession if you don’t do something about it.”

Here’s where it gets interesting. Historically, the Federal Reserve has been slow to read the tea leaves and roll out counter-cycle monetary policy. Is this time different? No one really knows at this point, although some business-cycle observers think that the central bank may be more proactive going forward compared with its history.

That’s a possibility worth entertaining, advises Tim Duy, a veteran Fed watcher who’s also an economics professor at the University of Oregon. “This cycle is unusual in that the Fed has cut rates already; in the past, they have continued to hike rates after a 10s2s inversion,” he explains. “I don’t like to say ‘this time is different’ given the yield curve’s past predictive ability, but the Fed’s response is different, and only time will tell if the early response is sufficient to avoid recession.”

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