The market’s most-popular recession warning is flashing red again as fears about the economic impact of China’s coronavirus outbreak prompt a big drop in Treasury yields.
Yet the warning—a drop in the 10-year Treasury yield below the three-month bill, known as an inverted yield curve—is signaling something much more benign: the expectation of Federal Reserve support later this year.
In fact, the yield curve is increasingly likely to miss the next recession anyway, because the Fed is already so close to zero.
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The 10-year yield has fallen below the three-month bill yield ahead of every recession since the 1960s. It has also sent two false alarms, in 1966 and briefly in 1998. Economists disagree about quite why it should predict recessions, but since no other method of predicting recessions has proved as reliable, investors tend to put a lot of weight on it.
The inversion which began last week looks more like the 1998 exception than it does the correct warnings, however. Prerecession yield curve inversions in the past occurred because investors believed that interest rates were temporarily too high as the Fed tried to slow the economy and reduce inflation.
That isn’t the case today and wasn’t in 1998. Far from trying to slow the economy, Fed Chairman Jerome Powell has been clear that the central bank stands ready to help. The yield curve has inverted not because investors think the Fed is in danger of raising rates too far, but because they are anticipating that rates will be cut even further. Rather than inverting because short-term bill yields went up, the curve has inverted because long-term bond yields have come down.
Federal-funds futures are pricing in at least one rate cut, and close to a 50% chance of two or more cuts this year. The three-month yield doesn’t reflect these cuts, but longer-term yields do, so long-run yields are below the three-month yield.
So far, so positive (assuming the Fed doesn’t derail markets by unexpectedly turning hawkish). Rather than pricing in a recession, investors are pricing in slower growth partially offset by cheaper money.
Unlike 1998, however, the Fed faces a new issue: Rates are getting uncomfortably close to zero once again. Futures put more than a one-in-six chance of rates below 1% by the end of the year. This appears to factor in the risk that government and consumer fears about the coronavirus infection prompt a sharp economic slowdown.
The Fed will be unable to respond to the next recession the way it did in prior downturns when it cut rates at least 5 percentage points. With rates currently at 1.5%-1.75%, it would have to rely on alternatives such as bond-buying and forward guidance, which are less-well tested as recession-busting tools.
Japan offers an important lesson from its two decades of near-zero rates: The yield curve offers no recession warning when the central bank is running low on ammunition.
Japan’s experience shows that when rates are on the floor, it is hard for the yield curve to invert. After the Bank of Japan slashed interest rates in the early 1990s, the yield curve failed to warn of all four (or six, depending on definition) subsequent recessions. Bond yields can approach zero, but unless a central bank takes rates negative it is very hard for bond yields to go lower, even when recessions are anticipated. Japan’s yield curve eventually inverted when rates went negative in 2016, but it was a false alarm and no recession followed.
So there is good news and bad news from the U.S. yield curve. This inversion is primarily technical, indicating that a dovish Fed is expected to offer support to the economy and markets. But as the Fed is driven closer to zero, the next recession might come without the handy warning of an inversion.
Write to James Mackintosh at James.Mackintosh@wsj.com
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