Market Extra: Should investors still worry if the yield curve sends this ominous signal?

Concerns over a potential inversion of the yield curve, a phenomenon seen as a reliable warning of impending economic distress—continue to wax and wane.

The yield curve is a line plotting the yields across Treasury maturities from the shortest dated to the longest. Typically, the curve slopes upward as investors demand more premium to hold debt for longer periods. In an inverted curve, the yield on a shorter dated maturity rises above a longer-dated maturity.

Talk of the curve gained new traction after Larry Fink, chairman and chief executive of BlackRock, the world’s largest asset manager and Dallas Federal Reserve Bank President Robert Kaplan separately voiced worries earlier this week that if the Fed was too aggressive with its monetary tightening, it could invert the curve.

“People are assuming another tightening this year and another three next year. Could we see an inverted yield curve like next year [or] early 2019? We want to avoid an inverted yield curve,” Fink told CNBC.

The last seven recessions were preceded by the yield curve, as measured by the yield spread between the yield on the 2-year

TMUBMUSD02Y, -1.31%

and 10-year Treasury notes

TMUBMUSD10Y, -1.93%

turning inside out.

If the central bank insists on maintaining its current tightening trajectory amid tepid inflation, Kaplan said the Fed would be at risk of making a serious policy mistake. The central bank’s dot plot, its officials’ forecasts for future interest rates, suggested the Fed would go forward with three rate hikes in 2018.

See: Investors fear a Fed policy misstep as central bank reaffirms rate-hike trajectory

After four rate increases in the current hiking cycle, the spread between the 5-year note

TMUBMUSD05Y, -2.13%

 and the 30-year bond

TMUBMUSD30Y, -1.50%

one gauge of the yield curve’s steepness often referenced by traders, narrowed to 0.91 percentage point, the tightest level in a decade.

Spread between 5-year yield and 30-year yield is at its narrowest in a decade

Others, like Lacy Hunt of Hoisington Investment Management, have highlighted a different kind of Fed mistake that could also lead to a recession. A bond bull, who predicted the 2007-2009 financial crisis, Hunt argued the balance sheet reduction would lead to a rapid fall in lending, throttling the economy, in an interview with Bloomberg News. The Federal Reserve announced it the unwinding of its $4.5 trillion portfolio, a form of monetary tightening, would begin on October.

A steeper yield curve is often a good proxy for a bank’s profits, as a wider spread can indicate the bank is making money from lending long and borrowing short. So the logic goes that if the yield curve flattens, thinner margins could discourage banks from issuing credit.

Echoing Hunt, Blackrock’s Fink told CNBC the shorter-end of the curve would rapidly rise because the maturities of the Treasurys rolling off the central bank’s portfolio mostly ranged between five to seven years. This would inject further momentum to the climb in shorter-dated yields, which were already marching higher along with the Fed’s rate hikes, while investors seeking yield snap up longer dated Treasurys. Yields fall as bond prices rise.

All the same, the curve is nowhere yet near flattening to the levels where it would prove a serious cause for concern. Marvin Loh, senior fixed-income strategist at BNY Mellon, said in the previous three hiking cycles, it took a much shorter time to invert the yield curve.

Less than two years into the current tightening cycle, the spread between the 2-year yield

TMUBMUSD02Y, -1.31%

  and the 10-year yield

TMUBMUSD10Y, -1.93%

  still stands at a positive 0.81 percentage point. By comparison, in the rate hike cycle beginning 2004, that yield gap flattened to zero in 18 months.

And it’s not clear that the curve’s Cassandra-like abilities will hold up the next time an economic crisis rears its head. In an era of unprecedented monetary policy and global demand for long-dated Treasurys, the usefulness of the indicator could be limited, said Subadra Rajappa, head of U.S. rates strategy at Société Générale.

Last February, strategists at the French investment bank removed the yield curve from their recession-forecasting model. They argued that even as the curve has flattened, there has been a lack of accompanying alarm bells that appear when the economy reaches the tail-end of its expansion. Wage growth has been mostly tepid, credit has remained easy, and corporate profits have steadied.

Moreover, long-dated yields might no longer serve as a reliable reflection of investors’ inflation expectations.

Yields for long-dated Treasurys have remained depressed thanks to the ballooning of central banks’ balance sheets in the wake of the 2007-2009 recession. The Bank of Japan, the European Central Bank and the Federal Reserve now hold more than $14 trillion of securities on their portfolios after they launched quantitative easing in a bid to stimulate their respective economies.

The balance sheets of the BOJ, ECB and the Fed now total $14.2 trillion

As a result, positive-yielding Treasurys were surrounded by a sea of low to negative yielding sovereign debt. Investors hunting for yield plowed into long-dated Treasurys.

In that environment, “the yield curve might not be a good predictor of inflation. The stock effect of central bank holdings, as well as the global savings glut, might mean there’s a different market dynamic in place,” Rajappa said.

Market participants shouldn’t take this as cause for complacency. The river of money sloshing around the globe in search of higher returns was the very reason that former Fed. Gov. Ben Bernanke used to deflect concerns that the yield curve’s inversion would soon lead to an economic slowdown in front of the Senate Banking Committee in 2007, Reuters reported.

Those soon became famous last words.