Wall Street’s favorite recession indicator is flashing yellow — but that may be about to change

  • The flattening of the yield curve, a bond market pattern that often portends recessions, has been a concern for some investors and Federal Reserve officials.
  • Lisa Hornby, a fixed-income portfolio manager at Schroder’s, tells us the Fed’s unwinding of its balance sheet will help blunt the recent flattening.
  • “At 50 basis points, there’s plenty of steepness still,” JPMorgan’s chief investment officer for fixed income, Nicholas Gartside, argues.

Investors and Federal Reserve officials have been quietly, and sometimes openly, fretting over the prospect of a bond market pattern that usually portends economic downturns.

The phenomenon, which entails long-term interest rates slipping toward and below their short-run counterparts and which is known as a flat (or eventually inverted) yield curve, was important enough to warrant significant debate at the Federal Reserve’s December policy meeting, according to minutes of the gathering. Those who are worried about this argue that if the Fed keeps raising short-term interest rates, the yield curve will flatten further – and they use it as an argument against rate hikes. But they neglect the other major element of the Fed’s so-called exit strategy: the gradual unwinding of Treasury and mortgage bonds accumulated during the financial crisis.

The Fed bought bonds in three rounds of quantitative easing, the stimulus known as QE, expanding its balance sheet to an unprecedented $4.5 trillion. It began moving in the other direction in October.

Lisa Hornby, a fixed-income portfolio manager at Schroders Investment Management, which oversees over half a trillion dollars in assets, told Business Insider this would help “steepen” the curve again, widening the gap between short- and long-term borrowing costs.

“The Fed is actively reducing its balance sheet and we’re seeing fiscal stimulus (in the form of tax cuts) at the same time as one of the biggest buyer of Treasury bonds is stepping back,” she said, adding that “should create some widening” in the spread between short- and long-term Treasury rates. The gap between 10- and two-year notes has recently been hovering at about half a percentage point.

That may not seem like much, but in the context of an official federal funds rate that is only in a range of 1.25% to 1.50%, 50 basis points is like a full third of the rate structure. The Fed has raised interest rates five times since December 2015, having left them at zero for seven years.

“I’m not worried about the yield curve giving a signal of something ominous,” Hornby said.

Nicholas Gartside, the chief investment officer for fixed income at JPMorgan Asset Management, told Bloomberg television from the World Economic Forum in Davos, Switzerland: “A flattening yield curve is actually very very healthy – the problem is when you get that yield curve inverting, and that’s the classic indicator for a recession. At 50 basis points, there’s plenty of steepness still.”

In a speech last week, the president of the Philadelphia Fed, Patrick Harker, sounded similarly optimistic.

“My assessment is that the worries so far have been inflated,” he said. “A flattening is often thought to be a precursor to a downward shift in overall economic conditions. However, that’s not a law of economic nature by any means, and consumer confidence is, in fact, high at the moment.”

Ward McCarthy, an economist at Jefferies, told Business Insider that looking at the spread between the shortest and longest maturities in the Treasury market, rather than the spreads between 10- and two-year notes or that between five- and 30-year maturities, was more useful.

“The gap between three-month bills and the 30-year bond is 149 basis points,” he said. “The gap between fed funds and the 30-year bond is 149 basis points – there is a long way to go.”

And a paper from the San Francisco Fed argues that this time is different when it comes to a flat curve because “a lower ‘normal’ interest rate, the risk of persistently low inflation, and fiscal and geopolitical uncertainty – may account for the yield curve flattening.”

Let’s hope they are right. Many economists were dismissive when the yield curve most recently inverted, yet it preceded the deepest US recession in generations.