Financial markets appear to be looking past a historic indicator of a potential recession, instead focusing on the path of U.S. monetary policy as the Federal Reserve continues to hike benchmark interest rates.

Equities this year have modestly rallied, gauges of fear in both the bond and stock markets remain well below where they were just a few months ago, and corporate bond-yield spreads are signaling a lower perceived risk of a recession. Meanwhile, short-term bond yields in the Treasury market have outpaced longer-dated yields for months in what would normally be a strong signal that an economic downturn is coming.

Rather than take the Treasury market's inverted yield curve at face value, however, investors have recognized that markets are intensely focused on the path of interest rates. That leaves traditional recession indicators less reliable than they historically have been and potentially signals that traders are already pricing in the Fed's next moves.

"I think markets see that the end [of rate hikes] is near," said Beth Ann Bovino, chief U.S. economist with S&P Global Ratings. "At least they see that the Fed is reaching its conclusion."

Yields and hikes

An inverted yield curve has preceded every recession in modern history, although not every inversion has been followed by a recession. Rather than just a potential signal of a recession, however, the ongoing movement of the curve better reflects investors' views of the Fed's policy path forward.

Since the Fed ended its pandemic-era policy of near-zero rates with its first rate hike in March 2022, the yield on the two-year bond yield has increased by 294 basis points. As the Fed has boosted its benchmark federal funds rate by 450 basis points over the past year, the yields on the 10- and 30-year bonds have increased by 189 bps and 157 bps, respectively.

"It appears investors see inflation to be problematic for the next one, two, three years and are pricing income-based assets accordingly," said Brian Luke, head of fixed income indices at S&P Dow Jones Indices. The fact that long-end rates are indeed lower points to the belief that markets would go back to "normal," he added.

That expectation toward normalcy could help explain recent moves in stocks, which have rallied modestly as the Fed has warned of additional rate hikes well into 2023.

"It could be viewed that equity markets are prepared for the storm and plan to ride it out, without further discounting assets and waiting for things to get cheap," Luke said. The S&P 500, for example, is up nearly 6% since the start of the year and just over 13% higher than its recent low point in October 2022.

Fear subsides

Smaller-cap stocks, which tend to be more aligned with economic growth, have outperformed large-cap stocks so far this year, but equities as a whole have climbed this year after a dismal 2022, a signal that the market impact of a potential recession may have already been felt.

"The stock market already priced in a mild recession when it was down 25% last year," said Paul Schatz, president of Heritage Capital. "And now it is trying to figure it all out."

If a recession risk is still looming, it does not top the list of worries for investors, Schatz said.

The CBOE Volatility Index — the equity market's so-called "fear gauge" — remains down about 40% from its peak. The ICE BofAML Move Index — the bond market's volatility gauge — is down more than 20% from its October 2022 peak.

The bond market appears to be bifurcated, said Sonu Varghese, a global macro strategist with Carson Group. While the yield curve remains extremely inverted, corporate credit markets are far more optimistic. High-yield spreads, for example, are lower than they were throughout much of the last decade and well below levels they were at during previous recessions, Varghese said.

"We're still in the process of normalizing post-pandemic," Varghese said. "We're not quite there yet."

Less dependable signals

This post-pandemic period, with decades-high inflation, decades-low unemployment and the most-aggressive acceleration of Fed policy in the central bank's history, has raised doubts about just how accurate market signals may be regarding the future health of the economy.

"As the evidence increasingly suggests that COVID may have marked an inflection point from persistent disinflation to sticky inflation, many traditional market indicators of imminent economic downturns may be less dependable in the years to come," said Matthew Weller, global head of market research with Forex.com and City Index.

Rather than looking to traditional market signals, such as the yield curve, analysts said that economic data, particularly jobs and inflation figures, provide a better picture of recession risk.

"The most important indicator I'm watching to gauge a potential recession is inflation data itself," said Jack McIntyre, portfolio manager at Brandywine Global. "The longer inflation remains elevated, the greater the odds it will take a recession to break it."

While market indicators remain important, they may be muted by changes in market structure following the pandemic and amid such an abrupt shift in monetary policy, said Callie Cox, a U.S. investment analyst at eToro.

"I think it's important to look at classic market indicators through a different lens," Cox said. "You don't have to throw out the old textbooks, you just have to acknowledge that this investor base is more educated and sophisticated than ever."