On 14 August, the yield spread between two-year and 10-year U.S. Treasury bonds moved below zero for the first time since February 2006. Though it has since widened back to positive territory, the move was significant because such “inversions” of the yield curve – in which short-maturity yields exceed those for longer-maturity bonds – have preceded nearly all recessions dating back to the 1950s. The move has also, understandably, made investors more wary of the economic outlook.

What’s behind the inversion – and are investors right to worry?

Researchers still struggle to understand why the yield curve historically is such a good predictor of recessions. Many hypothesize that when investors think a near-term economic downturn is becoming more likely, they prefer to hold longer-maturity bonds, causing the curve to invert. Others posit that a flat or inverted yield curve reduces the marginal profitability of new loans for bank and non-bank financial institutions (which tend to borrow short and lend long), thereby discouraging new credit creation and curbing economic activity.

Regardless of what underlies the relationship, we think markets are correct to price in a higher risk of recession. The U.S. has not been immune to the severe slowing in global industrial production and trade volumes. The U.S. manufacturing sector is already in a mini-recession (defined by two consecutive quarters of contraction), and weaknesses in sectors tied to the global economy (including manufacturing, exports, wholesale trade, and transport) have started to affect U.S. labor markets. In July, the six-month change in aggregate hours worked for production and non-supervisory workers contracted. And while indicators of real consumption growth have remained solid, the reduced hours paired with slower hiring should eventually hurt incomes and consumption.

Adding to these trends, tensions between the U.S. and China are heightening business uncertainties and disrupting global trade. Moreover, recent communications from some Federal Reserve officials have suggested that the Fed may be slower to react to a potential downturn, though various studies have shown that a “faster, sooner” central bank response could have economic benefits.

What will the Fed do?

For several quarters, we’ve argued that the Fed’s monetary policy strategy has shifted toward tolerating (or even targeting) inflation above 2% when economic conditions are good, and easing more aggressively when times are bad. Given secular trends that have depressed interest rates and reduced the central bank’s capacity to ease monetary policy through conventional means, central bankers should be more focused on keeping inflation expectations from slipping below the 2% target.

We’ve also argued that with manageable inflation and financial stability risks, easing more aggressively in response to the current slowing may be the less risky approach. However, comments from Fed Chair Jerome Powell and various regional Federal Reserve Bank officials since the July Fed meeting have raised questions about the Fed’s commitment to that policy approach. Chair Powell refrained from providing forward guidance on rates following the July meeting, instead emphasizing the Fed’s “data dependence.” Meanwhile, Boston Fed President Eric Rosengren dissented to the July rate cut, citing strong labor market momentum and near 2% inflation – indicators that traditionally lag the business cycle. Furthermore, Kansas City Fed President Esther George, who also dissented to the July rate cut, expressed support for a wait-and-see approach, and San Francisco Fed President Mary Daly was recently noncommittal when reporters asked if further easing is warranted. 

Recession isn’t a foregone conclusion

With all of this in mind, it’s not surprising that markets have priced in a higher probability of recession. But while we agree that the risk has risen, a recession over the next year or so is still not a foregone conclusion.

Unlike the lead-up to past U.S. recessions, today’s financial stability risks appear moderate, bank balance sheets are strong, household leverage is manageable, and the personal savings rate is high. All of these fundamental factors should help buffer an economic downturn.

The year-to-date decline in bond yields and still-easy financial conditions should also provide support to U.S. growth in the quarters to come, and despite some hesitancy, we believe the Fed will ultimately anchor lower interest rates by cutting its key policy rate later this year. Next week Chair Powell will speak on the “Challenges of Monetary Policy” at the annual Jackson Hole Economic Policy Symposium, where we expect him to clarify the central bank’s message and confirm the current market expectation for more easing.

Tiffany Wilding is an economist focusing on the U.S. and Anmol Sinha is a fixed income strategist. Both are contributors to the PIMCO Blog.