Why does the popular recession indicator no longer seem to work?

Wall Street’s favorite recession signal started flashing red in 2022 and hasn’t stopped — and so far it’s been wrong every step of the way.

Return on 10 year treasury bond U.S. bond yields have been lower than most of their shorter-term counterparts since then — a phenomenon known as an inverted yield curve that has preceded nearly every recession since the 1950s.

But while conventional thinking holds that a slowdown should occur within a year, or at most two, of the curve inverting, not only has that not happened, we don’t even have a red number on the horizon for US economic growth yet.

This situation has many on Wall Street scratching their heads about why the inverted curve — a signal, and in some ways a cause, of a recession — is so wrong this time, and whether it is a continuing sign of economic danger.

“So far, yes, it’s been a flat-out lie,” joked Mark Zandi, chief economist at Moody’s Analytics. “This is the first time that a reversal has happened without a recession. But having said that, I don’t think we can be comfortable with the reversal continuing. It’s been wrong so far, but that doesn’t mean it’s going to be wrong forever.”

Depending on which point of duration you think is most important, the curve has been inverted either since July 2022, as measured against the two-year note yield, or since October of the same year, as measured against the three-month note. Some even prefer to use the federal funds rate, which banks charge each other for overnight lending. That would bring the curve into inversion in November 2022.

Whichever point you choose, recession should have arrived by now. The reversal has been wrong only once, in the mid-1960s, and has predicted every austerity since.

The New York Fed, which uses a 10-year/3-month curve, expects a recession to hit in about 12 months. In fact, the central bank is still assigning about a 56% chance of a recession by June 2025, as the current gap suggests.

“It’s been so long that you have to start questioning its usefulness,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “I don’t see how a curve can be that wrong for so long. I’m leaning toward breaking it, but I’m not quite done yet.”

What makes the situation even more complicated is that the yield curve is not the only indicator showing reason to be cautious about how long the post-Covid recovery can last.

Gross domestic product, the tally of all goods and services produced across the sprawling U.S. economy, has averaged about 2.7% per year in real quarterly growth since the third quarter of 2022, a fairly solid pace well above what is considered a trend gain of about 2%.

Before that, GDP had been negative for two straight quarters, meeting the technical definition, though few people expect the National Bureau of Economic Research to declare an official recession.

The Commerce Department is expected to report on Thursday that gross domestic product accelerated by 2.1% in the second quarter of 2024.

However, economists have noted several negative trends.

The so-called Contribution Rule, a fail-safe measure that assumes recessions occur when the three-month average unemployment rate is half a percentage point above its 12-month low, is about to come into play. Moreover, the money supply has been on a steady downward trajectory since peaking in April 2022, and the Conference Board’s index of leading economic indicators has been negative for a long time, indicating significant headwinds to growth.

“A lot of these measures are questionable,” said Quincy Krosby, chief global strategist at LPL Financial. “At some point, we’re going to go into a recession.”

But there were no signs of a recession on the horizon.

“We have a number of different indicators that haven’t materialized,” said Jim Paulsen, a veteran economist and strategist who has worked at Wells Fargo and other companies. “We’ve seen a number of recession-like things.”

Paulsen, who now writes a blog on Substack called Paulsen Perspectives, points to some anomalies that have occurred over the past few years that could explain these disparities.

On the one hand, he and others note that the economy has already experienced that technical recession before the reversal. On the other hand, he cites the unusual behavior of the Federal Reserve during the current cycle.

Faced with runaway inflation at its highest rate in more than 40 years, the Fed began gradually raising interest rates in March 2022, then more aggressively by the middle of that year—after inflation peaked in June 2022. This is in contrast to how central banks have operated in the past. Historically, the Fed has raised interest rates early in the inflation cycle and then started cutting them later.

“They waited until inflation peaked, and then they tightened monetary policy to the max,” Paulson said. “So the Fed is completely out of sync.”

But price dynamics helped companies escape what usually happens in an inverted curve.

One reason that inverted curves contribute to recessions rather than signal them is that they make short-term money more expensive. This is difficult for banks, for example, which borrow in the short term and lend in the long term. As the inverted curve affects their net interest margins, banks may choose to lend less, causing consumer spending to decline and potentially leading to a recession.

But this time, companies were able to lock in low long-term interest rates before the central bank started raising rates, providing them with a buffer against higher short-term rates.

But this trend raises the risks for the Fed, as much of this funding is about to mature.

Companies that need to roll over their debt may have a tougher time if prevailing high interest rates remain in place. This could provide a kind of self-fulfilling prophecy for the yield curve. The Federal Reserve has been on hold for a year, with its benchmark interest rate rising to a 23-year high.

“So it’s possible that the curve has been lying to us so far. But it could decide to start telling the truth here soon,” said Zandi, the Moody’s economist. “I’m really uncomfortable that the curve has inverted. That’s another reason why the Fed is cutting rates. They’re taking a risk here.”