Inverted yield curve signals economic trouble ahead

“We don’t share the widespread concern about yield curve inversion,” Jan Hatzius, the bank’s chief economist wrote in a note Monday, cutting his assessment of the probability of a recession to 20% from 25%, following a lower-than-expected inflation report last week.  

Hatzius stands in opposition to most investors who point out that the curve inversion has an almost impeccable track record of foretelling economic downturns. The three-month T-bills yielded more than 10-year notes before each of the past seven US recessions. Currently, the short-term yields are more than 150 basis points above the longer-maturity notes, close to the biggest inversion in four decades.

Normally, the curve is upward sloped because investors demand higher compensation — or term premium — for holding longer-maturity bonds than short-term ones. When the curve turns upside down, it means investors are pricing in rate cuts large enough to overwhelm the term premium, such a phenomenon only occurs when recession risk becomes “clearly visible,” Hatzius explained.

This time, though, things are different, the economist said. That’s because term premium is “well below” its long-term average, so it takes fewer expected rate cuts to invert the curve. In addition, as inflation cools, it opens “a plausible path” to the Federal Reserve easing up on interest rates without triggering a recession, according to Hatzius. 

When economic forecasts became overly pessimistic, Hatzius added, they put downward more pressure on longer-term rates than justified.

“So the argument that the inverted curve validates the consensus forecast of a recession is circular, to say the least,” he wrote.