As Wall Street regains its footing following the invasion of Ukraine, stocks have been staging a steady comeback. But the market for US government bonds remains tumultuous, flashing a recession signal that's historically caused investors to worry.
What's happening: Yields on the two-year Treasury note, which move opposite prices, briefly rose above those on the benchmark 10-year note on Tuesday for the first time since September 2019.
That unusual inversion of the yield curve indicates that investors anticipate bigger risks to the economy in the near term that could prompt more dramatic action from policymakers like the Federal Reserve.
The big reason the move is generating so much attention is its fabled ability to predict the future. In 2018, the Federal Reserve Bank of San Francisco published research that found a yield curve inversion preceded every recession since 1955, producing a "false positive" just one time. (It looked specifically at the yield on 1-year Treasuries.)
Yet stocks are rising, and many experts think the US economy can stay solid. So do bond investors see something others are missing? Are those who point to the strong job market and healthy consumer demand failing to account for the effects of an energy price shock or looming interest rate hikes?
Not quite, according to Mislav Matejka, an equity strategist at JPMorgan. He emphasized to clients this week that the lag time between an inversion and a recession can "be very substantial, as long as [two] years" — and that stocks often perform very well during this interim period.
"From the point of curve inversion to the actual peak of the equity market, which takes place around a year later, [the] S&P 500 was higher by 15%, [versus] government bonds that tended to struggle in the meantime," Matejka wrote in a research note.
Paul Donovan, chief economist of UBS Global Wealth Management, is also skeptical of the inversion's importance. The market has changed significantly in recent years, as the Fed has bought up an unprecedented amount of government debt to stimulate the economy in the wake of the Great Recession and the pandemic, he pointed out. That's pushed down yields on longer-dated bonds.
"Bond markets are rigged, let's face it," Donovan told me.
Research published by the Fed's Board of Governors last week also warned against reading too much into a yield curve inversion.
"The perceived omniscience of the 2-10 spread that pervades market commentary is probably spurious," the paper said.
Doubters note the recent past. It's hard to claim the inversion in 2019 was a sign that investors foresaw the coronavirus pandemic in 2020, they argue.
That's not to say a recession is off the table. Goldman Sachs has put the chance of a recession in the United States over the next year as high as 35%.
"I think it's very fair to say recession risk has risen," Donovan said. "There is increased risk of [a] policy error, from the Fed in particular."
There's a lot of political pressure in the United States to fight inflation, he added. That creates a climate in which the Fed is more likely to move aggressively.
What should investors take away from the yield curve inversion, then?
It may just be telling us what we already know: that Wall Street thinks the Fed will need to get tough in the coming months to get inflation under control, and that engineering this policy shift without hurting the economy poses a major challenge.
