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One part of the U.S. yield curve just inverted; what does that mean?

Part of the U.S. Treasury yield curve “inverted” this week, setting off debate over whether it is delivering a classic signal of oncoming recession or it has just developed a short-term kink that can be explained away by technical reasons.

Whatever the reason, investors and economists ignore this message from the bond market at their peril: yield curve inversions – when shorter-dated securities yield more than longer maturities – have preceded every U.S. recession in recent memory by anywhere from 15 months to around two years.

“The yield curve has sent a chill down investors’ spines in regard to the future outlook of the U.S. economy,” said Chad Morganlander, senior portfolio manager at Washington Crossing Advisors in New Jersey. “It’s the what-if scenario.”

To be sure, this week’s inversion has been limited so far to the front-end of the yield curve rather than more closely studied recession harbingers such as the gap between 2-year and 10-year note yields. In the current instance, yields on 5-year notes US5YT=RR have dropped below those on both 2-year US2YT=RR and 3-year US3YT=RR securities.

Still, in December 2005, for instance, a comparable inversion at the front of the curve was followed shortly afterward by an inversion between 2- and 10-year yields. The Great Recession began in December 2007.

That pattern was also evident in late 1988 in advance of the 1990 recession. Ahead of the 2001 recession, the entire curve dropped into inversion in sync in February 2000.

TECHNICAL GLITCH OR FUNDAMENTAL WARNING?

In the current instance, investors and economists are debating whether this warns of economic weakness ahead or if it reflects other factors, such as a recent reversal of large speculative bets on declining bond prices and the Federal Reserve’s large holdings of Treasuries.

A central focus is whether it means the market is second guessing the Fed, which has been raising interest rates for three years and is expected to lift them further, including at their next meeting in two weeks.

Jeffrey Gundlach, chief executive officer of DoubleLine Capital and a closely watched bond investor, comes down on the side of it being a fundamental signal. It reflects “total bond market disbelief in the Federal Reserve’s prior plans to raise rates through 2019,” he told Reuters.

At the same time, this week’s move does coincide with an ongoing positioning shift in the Treasury market.

Hedge funds and other speculators had amassed a record level of bets on declines in Treasury prices through the futures market, with the heaviest bets lodged against 5-year maturities. But they have slashed those by more than half in the last few weeks, and that may have contributed to the out-sized rally in 5-year note prices in particular. Bond prices and yields move in opposite directions.

“A lot of it is momentum,” said John Canavan, market strategist with Stone & McCarthy Research Associates in New York. “I do think it’s overdone with short-covering and unwinding of money-losing positions.”

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