The inverted yield curve may have more to do with the Federal Reserve's mishandling of its forward guidance than any imminent recession.

After raising interest rates four times in 2018 and signaling two further hikes this year as recently as December, Fed Chairman Jerome Powell has done a rapid about-face, indicating in March that there will not be any more increases this year as concern that inflation would rise above the Fed's 2% target faded.

The implied yield on three-month Treasury bills climbed above the yield on 10-year notes on March 22, creating an inversion that has preceded every economic downturn since 1961. Typically the yield curve would trend upward as investors seek higher returns to compensate for the risk of holding longer-dated assets. The curve can invert when investors lose confidence in the economy, betting against further rate hikes and positioning themselves defensively in longer-dated U.S. debt which, as one of the most liquid assets in the world, is an established safe haven in times of stress.

The risk for the Fed is that an inverted yield curve may help push the U.S. economy into the recession that it is trying to avoid as it becomes a self-fulfilling prophecy. An inverted curve acts as a drag on bank profitability as lenders borrow on a short-term basis at higher yields than the returns they make on long-term loans, disincentivizing lending to the economy.

"The recent, perhaps extreme, paradigm shift at the Fed has really brought back this dovishness," Gregory Daco, chief economist at Oxford Economics, said in an interview. "Right now the biggest threat is the recession bias — people are increasingly worried."

Recession fears

Investors are increasingly skittish that the time to position defensively is here again as the economic cycle closes in on the record 120-month expansion in the 1990s. However, the Fed is still forecasting economic growth of about 2.1% in 2019.

"While the U.S. may be slowing as the fiscal stimulus boost fades, the economy is still growing close to trend, with a tight job market and financial conditions that have eased considerably this year," Andrea Iannelli, investment director at Fidelity International, said in an email.

Daco agrees that the economy is slowing and that recession forecasts based on the yield curve are "simplistic" and synonymous with an industry desperate not to be caught out by another major downturn.

The lag between an inverted yield curve and recession has historically been anything from six months to three years, and usually has to remain inverted for at least a quarter before it has a material effect on recession models. On one occasion in the 1960s, it did not herald a recession at all, according to research from the Federal Reserve Bank of San Francisco. This year's inversion ended March 29 and the yield on the 10-year note was 5 basis points above that implied on the three-month bill April 1.

Flatter curve

Traditionally, the Fed is blamed for creating inversions by hiking rates too quickly, steeply raising the front end of the curve around the two-year maturity. This time the inversion has been the result of a "bull flattener, meaning that the gap between long-dated and short-dated yields was shrinking on the basis of falling long-term yields rather than rising short-term yields," Eric Lascelles, chief economist at RBC Global Asset Management, said in an email.

Yields on longer-dated debt have been suppressed by quantitative easing as central banks hoovered up bonds to stimulate cheap borrowing. Researchers at the Fed estimate that the $1.5 trillion of QE purchases of Treasury securities reduced the term premium by about 60 basis points, Wells Fargo economist Jay Bryson wrote in a March 26 research report.