Part of the US Treasury yield curve "inverted" this week, setting off debate over whether it is delivering a classic signal of oncoming recession or it has just developed a short-term kink that can be explained away by technical reasons.

Whatever the reason, investors and economists ignore this message from the bond market at their peril: yield curve inversions - when shorter-dated securities yield more than longer maturities - have preceded every US recession in recent memory by anywhere from 15 months to around two years.

"The yield curve has sent a chill down investors' spines in regard to the future outlook of the US economy," said Chad Morganlander, senior portfolio manager at Washington Crossing Advisors in New Jersey. "It's the what-if scenario."

To be sure, this week's inversion has been limited so far to the front-end of the yield curve rather than more closely studied recession harbingers such as the gap between 2-year and 10-year note yields. In the current instance, yields on five-year notes have dropped below those on both two-year and three-year securities.

Still, in December 2005, for instance, a comparable inversion at the front of the curve was followed shortly afterward by an inversion between 2- and 10-year yields. The Great Recession began in December 2007.

That pattern was also evident in late 1988 in advance of the 1990 recession. Ahead of the 2001 recession, the entire curve dropped into inversion in sync in February 2000.

TECHNICAL GLITCH OR FUNDAMENTAL WARNING?

In the current instance, investors and economists are debating whether this warns of economic weakness ahead or if it reflects other factors, such as a recent reversal of large speculative bets on declining bond prices and the Federal Reserve's large holdings of Treasuries.

A central focus is whether it means the market is second guessing the Fed, which has been raising interest rates for three years and is expected to lift them further, including at their next meeting in two weeks.

Jeffrey Gundlach, chief executive officer of DoubleLine Capital and a closely watched bond investor, comes down on the side of it being a fundamental signal. It reflects "total bond market disbelief in the Federal Reserve's prior plans to raise rates through 2019," he told Reuters.

At the same time, this week's move does coincide with an ongoing positioning shift in the Treasury market.

Hedge funds and other speculators had amassed a record level of bets on declines in Treasury prices through the futures market, with the heaviest bets lodged against 5-year maturities. But they have slashed those by more than half in the last few weeks, and that may have contributed to the out-sized rally in 5-year note prices in particular. Bond prices and yields move in opposite directions.

"A lot of it is momentum," said John Canavan, market strategist with Stone &amp; McCarthy Research Associates in New York. "I do think it's overdone with short-covering and unwinding of money-losing positions."

Another current factor that was absent in previous inversion episodes is the Fed's $3.92 trillion stockpile of bonds accumulated to soften the effects of the 2008 financial crisis. While it has been shrinking its holdings for more than a year, its bond portfolio remains the world's largest and is seen as a force in suppressing longer-dated yields.

RECORD ECONOMIC EXPANSION

Those potential explanations aside, the US economy is in the middle of its second-longest expansion on record, and economists and investors are mindful that a downturn is inevitable.

Some business sectors like auto and housing are flagging due partly to rising interest rates, while debt-laden companies have raised concerns whether they could keep up with their debt payments as borrowing costs are rising.

Fed officials have cited these developments that bear watching, but several of them have repeatedly cautioned about the inversion of yield curve as the most reliable indicator that a recession is on the horizon.

Some traders said the dramatic curve flattening may be overdone and may revert if the government's November payrolls report out on Friday were to show solid jobs and wage growth.

While the risk of the entire yield curve inverting grows in anticipation of slower domestic growth, the economy appears on sure footing due to a solid job market and mild inflation.

Last year's massive federal tax cut has bolstered business confidence, but trade tension between Washington and major US trade partners looms as a possible economic drag, analysts said.

And, even if the latest kink in the yield curve is indeed the first signal of a downturn as many suspect, it does not indicate when it will actually begin nor how severe it will be.

"It’s a sloppy predictor because at some point after yield curve inversion you could get a recession that could be one year, two year, three years," said Nicholas Colas, co-founder at DataTrek Research in New York. "And as far as what it means to markets, you could still have another very solid year after inversion."

Part of the US Treasury yield curve "inverted" this week, setting off debate over whether it is delivering a classic signal of oncoming recession or it has just developed a short-term kink that can be explained away by technical reasons.

Part of the US Treasury yield curve "inverted" this week, setting off debate over whether it is delivering a classic signal of oncoming recession or it has just developed a short-term kink that can be explained away by technical reasons. Whatever the reason, investors and economists ignore this message from the bond market at their peril: yield curve inversions - when shorter-dated securities yield more than longer maturities - have preceded every US recession in recent memory by anywhere from 15 months to around two years. "The yield curve has sent a chill down investors' spines in regard to the future outlook of the US economy," said Chad Morganlander, senior portfolio manager at Washington Crossing Advisors in New Jersey. "It's the what-if scenario." To be sure, this week's inversion has been limited so far to the front-end of the yield curve rather than more closely studied recession harbingers such as the gap between 2-year and 10-year note yields. In the current instance, yields on five-year notes have dropped below those on both two-year and three-year securities. Still, in December 2005, for instance, a comparable inversion at the front of the curve was followed shortly afterward by an inversion between 2- and 10-year yields. The Great Recession began in December 2007. That pattern was also evident in late 1988 in advance of the 1990 recession. Ahead of the 2001 recession, the entire curve dropped into inversion in sync in February 2000. TECHNICAL GLITCH OR FUNDAMENTAL WARNING? In the current instance, investors and economists are debating whether this warns of economic weakness ahead or if it reflects other factors, such as a recent reversal of large speculative bets on declining bond prices and the Federal Reserve's large holdings of Treasuries. A central focus is whether it means the market is second guessing the Fed, which has been raising interest rates for three years and is expected to lift them further, including at their next meeting in two weeks. Jeffrey Gundlach, chief executive officer of DoubleLine Capital and a closely watched bond investor, comes down on the side of it being a fundamental signal. It reflects "total bond market disbelief in the Federal Reserve's prior plans to raise rates through 2019," he told Reuters. At the same time, this week's move does coincide with an ongoing positioning shift in the Treasury market. Hedge funds and other speculators had amassed a record level of bets on declines in Treasury prices through the futures market, with the heaviest bets lodged against 5-year maturities. But they have slashed those by more than half in the last few weeks, and that may have contributed to the out-sized rally in 5-year note prices in particular. Bond prices and yields move in opposite directions. "A lot of it is momentum," said John Canavan, market strategist with Stone & McCarthy Research Associates in New York. "I do think it's overdone with short-covering and unwinding of money-losing positions." Another current factor that was absent in previous inversion episodes is the Fed's $3.92 trillion stockpile of bonds accumulated to soften the effects of the 2008 financial crisis. While it has been shrinking its holdings for more than a year, its bond portfolio remains the world's largest and is seen as a force in suppressing longer-dated yields. RECORD ECONOMIC EXPANSION Those potential explanations aside, the US economy is in the middle of its second-longest expansion on record, and economists and investors are mindful that a downturn is inevitable. Some business sectors like auto and housing are flagging due partly to rising interest rates, while debt-laden companies have raised concerns whether they could keep up with their debt payments as borrowing costs are rising. Fed officials have cited these developments that bear watching, but several of them have repeatedly cautioned about the inversion of yield curve as the most reliable indicator that a recession is on the horizon. Some traders said the dramatic curve flattening may be overdone and may revert if the government's November payrolls report out on Friday were to show solid jobs and wage growth. While the risk of the entire yield curve inverting grows in anticipation of slower domestic growth, the economy appears on sure footing due to a solid job market and mild inflation. Last year's massive federal tax cut has bolstered business confidence, but trade tension between Washington and major US trade partners looms as a possible economic drag, analysts said. And, even if the latest kink in the yield curve is indeed the first signal of a downturn as many suspect, it does not indicate when it will actually begin nor how severe it will be. "It’s a sloppy predictor because at some point after yield curve inversion you could get a recession that could be one year, two year, three years," said Nicholas Colas, co-founder at DataTrek Research in New York. "And as far as what it means to markets, you could still have another very solid year after inversion."

Is recession setting in? Analysing the inverted US yield curve

The US economy may be basking in the warm glow of solid growth, but economists are nervously eyeing a trend in the bond market that could spell stormy weather ahead.&nbsp;Even though President Donald Trump is touting unemployment at its lowest level in 17 years and Wall Street soaring to new heights, economists are worried about one indicator that is often a harbinger of recession: the yield curve.

&quot;Since 1950, each recession has been preceded by a reversal of the yield curve&quot;, said Christopher Low, chief economist of FTN Financial.&nbsp;This closely scrutinized graph maps the difference in yield, or return on investment, of short- and long-term US Treasury debt, usually comparing two-year notes to 10-year bonds.&nbsp;

Normally, the shorter the investment, the lower the yield, and conversely, the longer the investment, the higher the return, to offset the greater risks of losing access to funds for an extended period.&nbsp;But for the past year, the yield curve has been flattening as the return on short-term debt has been getting close to long-term yields, possible signaling eroding confidence in the economy&#39;s performance in the coming years.&nbsp;

The spread between the yield on two- and 10-year Treasury paper fell from 135 in December 2016 to 51 basis points on December 15, the lowest since October 2007 -- just before the start of the global financial crisis.&nbsp;Worse still would be if the yield curve inverts, as short-term returns outpace the longer-dated debt -- meaning the spread is negative -- and if officials ignore the warning. The yield curve inversion &quot;could be heralding a contraction of the economy,&quot; says Gary Duncan, chief economist at Oxford Economics.

Fed policy&nbsp;

As Gregori Volokhine, of Meeschaert Financial Services, explained: &quot;An inversion of the curve indicates that investors do not have confidence in the future&quot;.&nbsp;The main factor behind the flattening of the yield curve is the US central bank&#39;s moves to raise the benchmark interest rate five times since the end of 2015, including three increases this year and three more expected in 2018.

The long-term yields fluctuate more in line with growth and inflation expectations. And while growth prospects have been revised upwards for next year -- in part due to the impact of the massive corporate tax cuts just approved by Congress -- the Federal Reserve&#39;s inflation target will not be reached until 2019, according to its latest forecasts.&nbsp;

The Fed&#39;s preferred inflation measure was only 1.6 percent year-on-year in October.&nbsp;Two voting members of the Fed&#39;s policy committee -- including Minneapolis Fed President Neel Kashkari -- dissented from the December 13 decision to raise rates, preferring to wait for inflation to rise further.

&#39;Worrying&#39;

Kashkari also mentioned his concerns about the yield curve and the signal it is sending to policymakers.&nbsp;&quot;While the yield curve has not yet inverted, the bond market is telling us that the odds of a recession are increasing,&quot; he said in a statement explaining his opposition to raising rates again.

Duncan of Oxford Economics cautioned that &quot;if the Fed tightens its policy too quickly, the markets anticipate a slowdown in the economy in the longer term&quot; as credit becomes more expensive.&nbsp;However, outgoing Fed Chair Janet Yellen downplayed those fears.

&quot;There are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed,&quot; Yellen said in her press conference last week.&nbsp;FTN&#39;s Low said Yellen could be making the same mistake as her predecessors Alan Greenspan in 1998 and Ben Bernanke in 2006, who each saw recessions after the yield curve inverted.&nbsp;

&quot;Janet Yellen is making the same speech,&quot; Low said. &quot;This is worrying&quot;. Like most analysts, Low does not anticipate an inversion before 2019, or a recession until &quot;early 2020&quot;.&nbsp;Historically the economy has seen four to six quarters between a curve inversion and the start a recession.

Of course, not every flat curve brings on an economic downturn, and some economists agree with Yellen that it may be too early to panic.&nbsp;Noted economist Mohamed El-Erian, the chief economic adviser at Allianz SE, the parent company of PIMCO, notes several reasons the yield curve could steepen, including many indicators signaling the economy still has room to expand and inflation to pick up.

If it doesn&#39;t, the Fed could reverse course quickly, he wrote in a blog post.&nbsp;In addition, &quot;the synchronized pick-up in growth in the rest of the world is supportive of the US expansion&quot;.

Economists are worried about one indicator that is often a harbinger of recession: the yield curve

The US economy may be basking in the warm glow of solid growth, but economists are nervously eyeing a trend in the bond market that could spell stormy weather ahead. Even though President Donald Trump is touting unemployment at its lowest level in 17 years and Wall Street soaring to new heights, economists are worried about one indicator that is often a harbinger of recession: the yield curve. "Since 1950, each recession has been preceded by a reversal of the yield curve", said Christopher Low, chief economist of FTN Financial. This closely scrutinized graph maps the difference in yield, or return on investment, of short- and long-term US Treasury debt, usually comparing two-year notes to 10-year bonds. Normally, the shorter the investment, the lower the yield, and conversely, the longer the investment, the higher the return, to offset the greater risks of losing access to funds for an extended period. But for the past year, the yield curve has been flattening as the return on short-term debt has been getting close to long-term yields, possible signaling eroding confidence in the economy's performance in the coming years. The spread between the yield on two- and 10-year Treasury paper fell from 135 in December 2016 to 51 basis points on December 15, the lowest since October 2007 -- just before the start of the global financial crisis. Worse still would be if the yield curve inverts, as short-term returns outpace the longer-dated debt -- meaning the spread is negative -- and if officials ignore the warning. The yield curve inversion "could be heralding a contraction of the economy," says Gary Duncan, chief economist at Oxford Economics. Fed policy As Gregori Volokhine, of Meeschaert Financial Services, explained: "An inversion of the curve indicates that investors do not have confidence in the future". The main factor behind the flattening of the yield curve is the US central bank's moves to raise the benchmark interest rate five times since the end of 2015, including three increases this year and three more expected in 2018. The long-term yields fluctuate more in line with growth and inflation expectations. And while growth prospects have been revised upwards for next year -- in part due to the impact of the massive corporate tax cuts just approved by Congress -- the Federal Reserve's inflation target will not be reached until 2019, according to its latest forecasts. The Fed's preferred inflation measure was only 1.6 percent year-on-year in October. Two voting members of the Fed's policy committee -- including Minneapolis Fed President Neel Kashkari -- dissented from the December 13 decision to raise rates, preferring to wait for inflation to rise further. 'Worrying' Kashkari also mentioned his concerns about the yield curve and the signal it is sending to policymakers. "While the yield curve has not yet inverted, the bond market is telling us that the odds of a recession are increasing," he said in a statement explaining his opposition to raising rates again. Duncan of Oxford Economics cautioned that "if the Fed tightens its policy too quickly, the markets anticipate a slowdown in the economy in the longer term" as credit becomes more expensive. However, outgoing Fed Chair Janet Yellen downplayed those fears. "There are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed," Yellen said in her press conference last week. FTN's Low said Yellen could be making the same mistake as her predecessors Alan Greenspan in 1998 and Ben Bernanke in 2006, who each saw recessions after the yield curve inverted. "Janet Yellen is making the same speech," Low said. "This is worrying". Like most analysts, Low does not anticipate an inversion before 2019, or a recession until "early 2020". Historically the economy has seen four to six quarters between a curve inversion and the start a recession. Of course, not every flat curve brings on an economic downturn, and some economists agree with Yellen that it may be too early to panic. Noted economist Mohamed El-Erian, the chief economic adviser at Allianz SE, the parent company of PIMCO, notes several reasons the yield curve could steepen, including many indicators signaling the economy still has room to expand and inflation to pick up. If it doesn't, the Fed could reverse course quickly, he wrote in a blog post. In addition, "the synchronized pick-up in growth in the rest of the world is supportive of the US expansion".

Could the 'curve' be warning of a US recession?

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Is recession setting in? Analysing the inverted US yield curve

Could the 'curve' be warning of a US recession?