The Federal Reserve's favorite recession indicator is flashing again! Is the American economy "red light"ed?

Typical recession warning signals are flashing in the US treasury market - the 10-year US treasury yield is lower than the 3-month US treasury yield, known as an inverted yield curve. Over the past few decades, this warning signal has had a reliable record of predicting economic recessions (occurring within 12-18 months after the signal appears). In fact, the New York Fed considers this to be a very reliable indicator, so they update this relationship monthly and provide the probability of an economic recession occurring within the next 12 months. At the end of January, when the 10-year US treasury yield was about 0.31 percentage points higher than the 3-month US treasury yield, the New York Fed's model showed a 23% probability of a US economic recession within the next 12 months. However, with the inversion of the 10-year and 3-month treasury yields, the likelihood of an economic recession has increased. RSM's Chief Economist Joseph Brusuelas said, "It is expected if investors take a more risk-averse stance out of concern for economic growth. This often happens in the late stages of the business cycle." "It is not yet clear whether this is more noise or a signal that we will see a significant slowdown in economic activity." Although the market is more closely monitoring the relationship between the 10-year and 2-year treasury yields, the Federal Reserve prefers the difference between the 10-year and 3-month treasury yields as a measure because the 3-month treasury yield is more sensitive to changes in the federal funds rate. However, the reliability of the 10-year-3-month treasury yield curve inversion as a predictor is not perfect. In fact, the last time this yield curve inverted was in October 2022, and the US economy did not experience a recession even two and a half years later. Therefore, the latest inversion of yields does not necessarily mean that an economic recession will definitely occur. But investors are worried that the ambitious economic agenda of US President Trump may not materialize. Following the US presidential election on November 5, 2024, the 10-year US Treasury yield began to rise. This is usually a clear sign that investors expect further economic growth. However, some market professionals point out that this also reflects investors' concerns about inflation and their demand for higher yields on government bonds amid the increasing US debt and deficit issues. Since Trump took office, the 10-year US Treasury yield has fallen significantly, dropping by about 32 basis points so far. This is because investors are concerned that Trump's tariff-focused trade agenda will push up inflation and slow down economic growth. In addition to the warning signal of the inversion of the 10-year-3-month treasury yield curve, a series of recent data releases also indicate signs of slowing economic growth. Data released on Tuesday showed that the US Conference Board's Consumer Confidence Index plummeted to 98.3 in February, the largest drop since August 2021, well below the economists' estimate of 102.5, and even lower than the most pessimistic forecast of 99.3. The US Conference Board's Consumer Expectations Index dropped from 82.2 to 72.9 in February. A drop in the Expectations Index below 80 is usually seen as a signal of economic recession. This is the first time since June 2024 that the Expectations Index has fallen below 80, signaling an economic recession, and marking the largest monthly decline since August 2021. Before the 2008 financial crisis, the Expectations Index continued to decline, providing early warnings of consumer contraction and economic recession risks. Meanwhile, data released last Friday showed that the University of Michigan's one-year inflation rate expectation for the US rose to 4.3% (up from 3.3%), and the University of Michigan's five-year inflation rate expectation for February rose to 3.5% (up from 3.2%), reaching the highest level since 1995. On one hand, there are concerns about economic recession, on the other hand, there are concerns about high inflation, this combination is considered as "economic poison" - the warning of a recession and rising inflation, shaking the narrative foundation of the "Fed's perfect rate cut." However, some other indicators, including consumption and labor markets, still show resilience in the US economy. PGIM Fixed Income's Chief US Analyst Tom Porcelli said, "We do not expect a recession, but we do expect economic activity to be softer in the next year." The market also seems to agree with the view that US economic activity will weaken. Traders have resumed betting on the Fed cutting rates twice this year and once next year to around 3.65%, indicating that traders believe the Fed will loosen monetary policy to support the economy as growth slows. FWDBONDS Chief Economist Chris Rupkey said the bond market is smelling the "scent of economic recession in the air." But Chris Rupkey is not sure if an economic recession will actually occur, as there are no signs yet in the labor market indicating an impending recession. He says the inverted yield curve is "purely because the economy is not as strong as people thought early in the Trump administration," and "I don't know if we are predicting a full-blown recession, an economic recession needs unemployment numbers (to prove it)."