The Treasury yield curve inversion has many on Wall Street predicting the economy will tumble into a recession.

The Treasury yield curve made headlines recently. Parts of the U.S. government bond yield curve — which plots bond yields with differing maturity dates — inverted for a few days in March. The yield on the 10-year note dipped below the yield on 3-month bills for the first time since mid-2007. But does this mean a recession is imminent? We have to analyze several factors, including statistics, economic conditions, and asset prices, to gauge this risk.

Even with the yield curve's track record for predicting recessions, there is no such thing as certainty in economic forecasting. Statistically, an inverted yield curve has signaled the past seven recessions in the United States. However, in three of the past 10 times when the curve inverted, there was no recession in the following two years. Moreover, the lead time between an inverted curve and a downturn varies: During the past seven recessions that followed an inversion, the lead time was eight to 22 months.

Global themes influence U.S. rates

So, let's think about the inversion from an economic standpoint. Some economists view the current 10-year bond yield as a projection of the future policy rate. This is when the market starts to price in a central bank rate cut that will slow any potential recession. We, however, doubt this is the right way to think about the world. The term points on the yield curve don't necessarily reflect the market's view about the federal funds rate. The United States is an open economy, and we believe the movements in the 10-year Treasury are influenced by global forces.

There is a global supply and demand for low-risk bonds, such as Treasuries and German Bunds. Global central banks, including the ECB and the Bank of Japan, sell, buy, and hold low-risk bonds in their reserves. Pension funds also drive the very long end of the Treasury yield curve because not many other institutions want to hold these long-duration assets. There is also demand from the international private sector. In sum, U.S. rates are increasingly determined by global — not local — factors. Global interest rates are held down by the inflows of capital from countries with current account surplus searching for safer assets and by large foreign central banks keeping their policy rates essentially at zero.

Part of yield curve inverts as 10-year yield drops below 3-month rate

Risky assets matter

There is one other way in which an inverted yield curve matters for the outlook. The central bank and the 10-year note determine the term premiums that investors demand to hold Treasuries. A term premium is the amount by which the yield to maturity of a long-term bond exceeds that of a short-term bond. If the central bank's rate is higher than the yield on the 10-year note, market players will try to end the inversion. Investors will reduce their duration exposure because they can get returns at the front end of the curve. In recent days, large inflows into short-term Treasuries have pushed yields lower. A term premium is, itself, a risky asset. Investors want to be compensated with higher yields for assuming the added risk of future inflation.

A persistent inversion is a threat to the performance of risky assets.

Risky assets are correlated. When there is euphoria or a panic in the markets, risky assets trade in line with their betas (the historical measure of risk of any individual asset or portfolio). Investor appetite for risky assets and market movements is highly correlated. During normal periods, there is more dispersion around the trendline, but assets are still correlated. If the term premium is negative, risky assets provide a negative return. This is why inversions matter. A persistent inversion is a threat to the performance of risky assets. If risky assets underperform, the risk of a recession rises.

Coming full circle

As bond spreads rise and stocks decline, the corporate sector's cost of capital increases. Companies are likely to cut back on investments and borrowings. As this happens, the labor market weakens. This can lead to a drop in household confidence and wealth, prompting consumers to alter their spending habits. Before you know it, the economy is slumping. A central bank can influence this process: It can view the inversion as irrelevant and keep its policy rate on its predetermined course, or it can view the inversion as a worrying sign and respond by lowering rates.

There is a "Fed put" on asset prices; no sensible central bank would want to see sustained weakness in asset prices. The Fed put is the belief that the central bank can rescue the U.S. economy by lowering interest rates. But central banks also want to see some asset price volatility to keep market participants on their toes and to prevent inappropriate risk taking. So, a central bank can't overreact to volatility in risky assets, just as it can't overreact to pockets of weak or strong economic data.

Do inversions matter?

So, does the recent inversion matter? Maybe it does. While the inversion in and of itself it is not a harbinger of recession, it is a sign that something is awry. We would like to see a steeper curve. Long-term bond yields are unlikely to rise to produce a steeper yield curve due to the large capital surpluses in advanced economies, the lack of inflation pressures, and the lack of a clear source for global growth. The more likely path to a steeper yield curve is through interest-rate cuts. So, if long-term bond yields do not rally, the inversion returns and persists, and the Fed does not respond, we'll have a problem.

Next: Europe at a crossroad

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The global economy is showing a few tentative signs of improvement, but risks remain.