Bond market flashes yield curve warning

As reported by Bloomberg, a yield curve inversion of the 3- and 5-year US Treasuries is flagging a growing warning sign, and could be signaling for the key pre-recession yield inversion of the 2- and 10-year yields.

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Earlier this week, interest rates on 3-year Treasury notes turned higher than 5-year rates for the first time since the dawn of the previous U.S. recession, back in 2007. This is called an inversion of the yield curve, or at least a small piece of the curve. The Big One will be when 2-year and 10-year Treasury rates swap places, and bond traders are doing their darnedest to make it happen soon, as Robert Burgess points out. That particular inversion has preceded every recession since the late 1970s.

But it’s worth asking why the yield curve is such an uncanny predictor of recessions (and no, it’s probably not different this time). Karl W. Smith suggests the market is pricing in lower Fed rates in the future, either to end a recession or to prevent one. A recession isn’t destiny, in other words: The Fed could respond to the yield curve’s signal by cutting rates to head off the recession. But this would require a level of forward thinking the Fed hasn’t shown in the past. Usually it just keeps raising rates, yield curve be damned, and it may be about to make the same mistake, Karl writes.

Another big recession indicator is the recent weakness in housing. This, along with growing volatility in stocks, could help explain why high-income Americans are more pessimistic about the economy than low and middle earners these days – an unusual situation, as Danielle DiMartino Booth notes. High earners do the bulk of consumer spending, which is the life blood of the economy. If they cut back, then a recession becomes more likely, Danielle writes.

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