Many investors worry that a steep recession or a market crash may be looming, but the academic researcher who first established the relationship between the yield curve and recessions says that the U.S. economy is likely to see only a modest downturn. In fact, that high degree of concern should limit the damage. “That increases the probability of a soft landing,” says Campbell Harvey, a senior adviser at Research Affiliates and a professor of finance at Duke University, in an interview with MarketWatch.

Specifically, Harvey's recent research in the area of behavioral economics finds that unanticipated economic slowdowns tend to get magnified as panicked companies slash payrolls and investment. However, when they anticipate an economic contraction, they tend to respond in a less severe fashion. In the aftermath of the 2008 financial crisis, investors, analysts, and businesses alike have remained on heightened alert for potential signs of a recession ahead, he notes.

Key Takeaways

  • An inverted yield curve often signals an oncoming recession.
  • However, widespread fears of a recession may be a positive.
  • Unexpected slowdowns spark drastic job and investment cuts.
  • When recessions are anticipated, these cuts are less severe.
  • Expected slowdowns thus tend to be shorter and milder.

Significance for Investors

Harvey published a research paper three decades ago that detailed how an inverted yield curve, with short term rates exceeding long term rates, often predicts an oncoming recession. As a result of a lengthy inversion in 2019, many observers have been on heightened alert for additional indicators of a recession ahead.

A common method for assessing the shape of the yield curve is to compare the yields on the 3-month U.S. Treasury Bill and the 10-year U.S. Treasury Note. For the vast majority of the time since May 23, the former has exceeded the latter, indicating an inverted yield curve. There also were shorter-lived inversions earlier in 2019.

Meanwhile, the Federal Open Market Committee (FOMC) has released the minutes of its Sept. 17-18, 2019 meeting, at which it decided to cut the federal funds rate to a range of 1.75% to 2.00%. "Softness in business investment and manufacturing so far this year was seen as pointing to a more substantial slowing economic growth than the staff projected," the minutes noted, as quoted by CNBC. "A clearer picture of protracted weakness investment spending, manufacturing production, and exports had emerged," the minutes also said.

While FOMC members were monitoring the yield curve inversion, which they believe to be a reliable indicator of a recession ahead, they also found current economic conditions to be strong. In particular, they called consumer spending "robust" amid an employment picture that continues to improve.

Looking Ahead

While an inverted yield curve is generally taken as a bearish indicator for the economy and stocks, an extended period of stock market gains typically follows, per analysis by Dow Jones Market Data cited by The Wall Street Journal. Meanwhile, both investment research firm Bespoke Investment Group and macro investment analytics firm Bianco Research have found that not every inversion has been followed by a recession, per a pair of articles in Barron's. Additionally, Bespoke confirmed the Dow Jones finding that stock market gains often follow inversions.