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Don't sweat the inverted yield curve and its recession warning, experts say

·Editor focused on markets and the economy

Recently, U.S. bond investors spooked financial markets by demanding a higher premium on shorter-dated government debt when compared to longer-term bonds.

Specifically, the yield on the 10-year Treasury note fell below the rising yield on the 3-month Treasury bill for the first time since 2006. Dubbed the yield curve inversion, the phenomenon often presages recession.

Against a backdrop of a softening global economy, the inversion has put Wall Street on edge. However, a growing number of observers have a message for the markets: Relax.

A premium on shorter-term rates “is an important phenomenon and one ought not ignore it, but from our perspective more important than the shape of the curve is the level of rates,” said Krishna Memani, CIO of OppenheimerFunds, which has over $229 billion in assets under management.

Despite the Federal Reserve’s rate hiking campaign that came to an end in December, its relatively loose policy has kept the overall level of rates low for the better part of the past decade and continues to be “more supportive than it has been for a long time,” he added.

On Monday, former Federal Reserve chair Janet Yellen stated that the rise in short-term rates was not a sign of a recession, but could be suggesting a coming interest rate cut by the Fed.

“Certainly the market is flashing warning signs, and investors are buying intermediate-term debt hand over fist,” said Andrew Szczurowski, a portfolio manager and vice president at Eaton Vance, who manages a government debt fund worth $4 billion.

Given that the Treasury curve has been flattening for several years because of the Fed’s quantitative easing, “this time is different for a number of reasons,” Szczurowski added. “The market’s getting a little ahead of itself.”

JPMorgan analyst Marko Kolanovic also acknowledges that this time is different, noting that the 10-year note’s yield has been “kept artificially lower by zero or negative yields outside of the U.S....significant QE activity, and carry trades.”

‘Scaring people into wrong facts’

Meanwhile, opinions differ sharply on the exact segment of the yield curve that some analysts are using to gauge the potential for a recession. On Tuesday, Goldman Sachs analysts argued investors shouldn’t use the 3-month bill/10-year yield as a recession gauge, but instead should look at the 2-year/10-year differential.

That argument was reinforced by Brian Belski, Bank of Montreal’s chief investment strategist, who said the recent gap between short and long-term yields “has caused a tremendous amount of conjecture and diatribe” from market watchers that are “scaring people into wrong facts and analysis.”

Some of the angst was assuaged on Tuesday, when the government’s 2-year auction was met with strong investor demand, driving up prices on shorter-dated paper and pushing down yields.

Belski argued that the differential between 2-years and 10-years is still positive, and historically has been bullish for stock investors.

“We believe investors should not start to worry unless and until this yield curve inverts,” he said. Belski also cited data showing that annualized returns on the S&P 500 (^GSPC) averages more than 12% when yields flatten.

Even if short-term investors are nervous about the economy, an inverted curve does not suggest “imminent doom for stocks,” the analyst said, emphasizing that the lag between inversion to a downturn usually involves a period of at least a year.

The mitigating factor in any downturn is the Fed. Some are betting the central bank could be forced to cut rates sometime this year, if the economic soft patch becomes a ditch.

“The fed’s goal is to minimize a drawdown in the economy,” said OppenheimerFunds’ Memani.

“That concern is far more acute today than it was in the 90s and 2000s, because they recognized that if the economy got into a recession, their tools are significantly more limited than before,” he said. “To a large extent, the December pivot and January surrender [on hiking rates further] was a policy driven by that fear.”

Javier David is an editor for Yahoo Finance. Read more:

Follow Javier on Twitter: @TeflonGeek

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