What is the ROI? Wall Street’s recessionary alarm rings.

Wall Street’s most talked about recession indicator hits its highest alarm in two decades, reinforcing investor concern that the US economy is heading for a downturn.

This indicator is called the yield curve, and it is a way to show how yields on various US government bonds are compared., especially three-month bills and two- and 10-year government bonds.

Bond investors generally expect to be paid more to unlock their money over a longer period of time, so interest rates on short-term bonds are lower than on long-term ones. Plotted on a chart, the various bond yields create an upward line ̵[ads1]1; the curve.

But sometimes short-term interest rates rise over long-term ones. The negative relationship distorts the curve to what is called an inversion, and signals that the normal situation in the world’s largest government bond market has been lifted.

An inversion has preceded every American recession in the last half century, so it is seen as a harbinger of economic downturn. And it’s happening now.

The yield curve has predictive power that other markets do not have.

On Wednesday, the yield on two-year government bonds was 3.23 per cent, above 3.03 per cent on 10-year bonds. A year ago, by comparison, two-year interest rates were more than one percentage point lower than 10-year interest rates.

The Fed’s mantra about inflation at the time was that inflation would be temporary, which means that the central bank did not see a need to raise interest rates quickly. As a result, short-term interest rates on the Treasury remained low.

Over the past nine months, however, the Fed has become increasingly concerned that inflation will not decline by itself, and it has begun to cope with rapidly rising prices by raising interest rates rapidly. By next week, when the Fed is expected to raise interest rates again, the key interest rate will have jumped by around 2.5 percentage points from close to zero in March, and this has pushed up interest rates on short-term government bonds such as the two-year note.

Investors, on the other hand, have become increasingly afraid that the central bank will go too far, slowing the economy to such an extent that it will trigger a severe downturn. This concern is reflected in falling more-dated government interest rates as 10-year, which tells us more about investors’ expectations for growth.

Such nervousness is also reflected in other markets: US equities have fallen nearly 17 percent so far this year, as investors reassess companies’ ability to withstand a downturn in the economy; the price of copper, a global watch due to its use in a variety of consumer and industrial products, has fallen above 25 percent; and the US dollar, a haven during periods of worry, is at its strongest in two decades.

What separates the yield curve is its predictive power, and the recession signal it is sending right now is stronger than it has been since the end of 2000, when the bubble in technology stocks had begun to burst and a recession was only a few months away.

That recession occurred in March 2001 and lasted for about eight months. When it started, the yield curve was already back to normal because politicians had begun to lower interest rates to try to get the economy recovering.

The yield curve also predicted the global financial crisis that began in December 2007, which originally reversed at the end of 2005 and remained so until mid-2007.

This is the reason why investors across the financial markets have noticed now that the yield curve has reversed.

“The yield curve is not the gospel, but I think it’s at your own risk to ignore it,” said Greg Peters, chief investment officer at PGIM Fixed Income.

But which part of the yield curve matters?

On Wall Street, the most referenced part of the yield curve is the ratio between two- and 10-year interest rates, but some economists prefer to focus on the relationship between the return on three-month notes and 10-year notes instead.

This group includes one of the pioneers in research on the predictive power of the yield curve.

Campbell Harvey, now a professor of economics at Duke University, recalls that he was asked to develop a model that could predict US growth while he was a summer intern at the now defunct Canadian mining company Falconbridge in 1982.

Mr. Harvey turned to the yield curve, but the United States was already in a recession for about a year, and he was soon laid off due to the economic climate.

It was not until the mid-1980s, when he was a Ph.D. graduate of the University of Chicago, that he completed his research which showed that an inversion of three-month and 10-year returns preceded recessions that began in 1969, 1973, 1980 and 1981.

Mr Harvey said he preferred to look at three-month interest rates because they are close to current conditions, while others have noted that they more directly capture investors’ expectations of immediate changes in Fed policy.

For most market monitors, the different ways of measuring the yield curve point, largely in the same direction, and signal declining economic growth. They are “different tastes,” said Bill O’Donnell, an interest rate strategist at Citibank, “but they are still ice cream.”

Three-month yield remains below 10-year yield. So with this target, the yield curve has not reversed, but the gap between them has shrunk rapidly as concerns about a decline have escalated. On Wednesday, the difference between the two returns had fallen from over two percentage points in May to around 0.5 percentage points, the lowest it has been since the pandemic-induced decline in 2020.

The yield curve can not tell us everything.

Some analysts and investors argue that attention to the yield curve as a popular recession signal is exaggerated.

A common criticism is that the yield curve tells us little about when a recession starts, only that there will probably be one. The average time to a recession after two-year interest rates have risen above 10-year interest rates is 19 months, according to data from Deutsche Bank. But the range goes from six months to four years.

The economy and financial markets have also developed since the financial crisis in 2008, when the model was last in vogue. The Fed’s balance sheet has increased as it has repeatedly bought government bonds and mortgages to support the financial markets, and some analysts claim that these purchases could distort the yield curve.

These are both points that Mr. Harvey accepts. The yield curve is an easy way to predict the path of growth in the US and the potential for a recession. It has proven reliable, but it is not perfect.

He suggests using it in conjunction with surveys of financial expectations among CFOs, who usually cut back on corporate spending as they become more concerned about the economy.

He also pointed to the company’s borrowing costs as an indicator of the risk investors perceive when lending to private companies. These costs tend to rise when the economy slows down. Both of these measures tell the same story right now: the risk is increasing, and the expectations of a decline are increasing.

“If I were back in summer practice, would I just look at the yield curve? No,” Mr. Harvey said.

But that does not mean that it has ceased to be a useful indicator.

‘It’s more than helpful. It’s quite valuable, “said Mr. Harvey. “It is the responsibility of every company’s manager to take the return curve as a negative signal and engage in risk management. And for humans too. Now is not the time to maximize your credit card on an expensive vacation. “