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Wednesday, March 23, 2022

Investors like to look at a squiggly line known as the yield curve to measure market sentiment about the future.

When the line has a neat and upward slope, investors generally go about their days without paying any mind to the line. But when the line loses its shape, the U.S. economy might, uh, tilt into a recession.

Maybe.

The yield curve plots out yields on U.S. Treasuries (debt of the U.S. government) of varying maturities.

In normal times, yields on shorter-duration Treasuries fetch a lower return than those that are longer duration (to compensate for the risk of holding the security for longer). This is the neat and upward line.

In abnormal times, yields on longer-duration U.S. Treasuries dip below shorter-duration ones. This makes for a line that loses its upward slope, and signals some dynamic at play that is distorting how people view duration risk.

Let’s look at where we’re at using a different view of the yield curve: measuring the difference between the yields on the U.S. 10-year and the 2-year.

The difference is less than 0.20% as of March 22. An inversion would be reflected by a figure below 0. Each of the last eight recessions in the U.S. have been preceded by an inversion in this specific measure (with a lead time of between eight months to two years).

[Read: Bonds, yields, and why it matters when the yield curve inverts — Yahoo U]

So are we headed into a recession? The news cycle might suggest so. High inflation in the U.S. and a war in Ukraine could tilt the U.S. economy into a recession — just after we emerged from the pandemic-induced one.

But others argue that the explanation here is simple: The Federal Reserve has its fingerprints all over the curve. The central bank is raising interest rates, which has the relatively direct impact of lifting shorter-term rates. To a lesser degree, the Fed may also have an impact on longer-term rates because it snatched up a lot (over $3 trillion!) of U.S. Treasuries since the beginning of the pandemic.

“That [yield curve] signal is heavily distorted by the Fed's massive balance sheet and extremely low bond yields overseas,” warned BofA Global Research’s team in February.

Guy LeBas, chief fixed income strategist at Janney, also pointed out to Yahoo Finance that the curve is steeper now than it was when the Fed began a cycle of rate increases in 1999.

There’s also the fact that recessions tend to happen every 10 years or so. If a recession doesn’t rear its head until up to two years after a yield curve inversion, is the signal functioning more like a broken clock?

Take a look at the August 2019 inversion. A recession did happen a year and a half later. But it was triggered by a global pandemic — something bond markets could not have possibly foreseen or predicted.

Given the importance of the Fed in the shape of the line, no one has more say on this than Fed Chairman Jerome Powell.

“We monitor a broad range of financial conditions. And the shape of the yield curve is just one thing. We do look at that. And we look at different measures,” Powell said Monday.

So, look at it. And make of it what you will.

By Brian Cheung, an anchor and reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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