The US economy may be fueling solid growth, but economists are nervously watching a trend in the bond market that could herald a stormy weather.
Even though President Donald Trump is touting unemployment at its lowest level in 17 years and Wall Street is reaching new highs, economists worry about an indicator that often announces the recession: the curve rates.
"Since 1950, every recession has been preceded by a reversal of the yield curve," said Christopher Low, Chief Economist of FTN Financial.
This carefully researched graph shows the difference in return, or return on investment, of the US Treasury's short and long-term debt, usually comparing two-year bonds to ten-year bonds.
Normally, the shorter the investment, the lower the return and, conversely, the longer the investment, the higher the return, to offset the increased risk of losing access funds for an extended period.
But for the past year, the yield curve has flattened out, with short-term debt yield approaching long-term returns, a possible sign of erosion of confidence in the performance of the economy in the coming years.
The gap between two- and ten-year Treasury bill yields fell from 135 in December 2016 to 51 basis points on December 15, the lowest since October 2007 – just before the onset of the crisis financial world.
Even worse if the yield curve is the opposite, because short-term returns outweigh longer-term debt – which means the spread is negative – and the authorities ignore the warning.
The inversion of the yield curve "could herald a contraction of the economy," says Gary Duncan, chief economist at Oxford Economics.
As Gregori Volokhine, of Meeschaert Financial Services explains: "A reversal of the curve indicates that investors do not have confidence in the future."
The main factor explaining the flattening of the yield curve is the US central bank's decision to increase the benchmark interest rate five times since the end of 2015, including three increases this year and three more in 2018.
Long-term returns fluctuate more depending on expectations of growth and inflation. And if the growth outlook has been revised upward for next year – partly because of the impact of the massive tax cuts decided by Congress – the goal of ####################################################### Federal Reserve inflation will only be reached in 2019, according to its latest forecasts.
The Fed's preferred inflation measure was only 1.6% yoy in October.
Two voting members of the Fed's political committee – including Minneapolis Fed President Neel Kashkari – were dissidents of the December 13 decision to raise rates, preferring to wait for inflation to rise again.
Kashkari also raised concerns about the rate curve and the signal it sends to policy makers.
"While the yield curve is not yet reversed, the bond market tells us that the probabilities of a recession increase," he said in a statement explaining his opposition to a further rise in rates.
Duncan of Oxford Economics warned that "if the Fed is tightening its policy too quickly, markets are planning a longer-term slowdown in the economy" as credit becomes more expensive.
However, outgoing Fed President Janet Yellen downplayed these fears.
"There is good reason to think that the relationship between the slope of the yield curve and the business cycle may have changed," Yellen said at a press conference last week.
FT Lowell said that Yellen could make the same mistake as his predecessors Alan Greenspan in 1998 and Ben Bernanke in 2006, who have each seen recessions after inverting the yield curve.
"Janet Yellen makes the same speech," Low said. "It's disturbing."
Like most analysts, Low does not anticipate a reversal before 2019, nor a recession before "early 2020".
Historically the economy has seen four to six quarters between a curve reversal and the beginning of a recession.
Of course, not all flat curves entail any economic downturn, and some economists agree with Yellen that it may be too early to panic.
Economist Mohamed El-Erian, chief economic advisor at Allianz SE, parent company of PIMCO, notes several reasons why the yield curve could strengthen, including many indicators indicating that the economy has still margin and inflation. ]
If this is not the case, the Fed could reverse the trend quickly, he writes in a blog post.
In addition, "the synchronized recovery of growth in the rest of the world supports US expansion."