By Ben Eisen 

Investors may not be able to count on a once-reliable economic warning bell to ring before the next recession.

Before every one of the past seven U.S. recessions, long-term interest rates fell below short-term rates, producing what economists call a yield curve inversion. Historically, the slope of the yield curve has been such a reliable predictor of economic conditions that economists at New York and Cleveland Federal Reserve banks use it to calculate the probability of recession.

Ultralow yields on short-term bonds, however, may prevent the yield curve from inverting even if the economy is about to contract.

The yield curve is a graph of interest rates arranged in order of bond maturities. Normally, it slopes upward because long-term interest rates are higher than short-term rates to compensate investors for accepting increased risk. Long-term bond yields are thought to reflect the average of future short-term interest rates expected over the life of the bond plus this so-called term premium.

When the yield curve steepens, it usually reflects expectations of higher short-term rates in the future, signaling economic growth. A flattening curve indicates expectations that rates will tumble. That typically happens because the market anticipates the Federal Reserve will ease monetary policy to stimulate a slowing economy. An inverted yield curve implies the market expects short-term rates to fall sharply and stay persistently low, signaling an economic contraction.

The difference between yields on 3-month Treasury bills and 10-year notes is regarded by economists at the Fed as the best yield curve predictor of recessions. This is currently at 1.54 percentage points, according to Tradeweb. That is down roughly half a percentage point since the end of last year, but remains wide by historical standards. By the New York Fed's calculation, this means there is less than a 5% chance of a recession in 12 months. The Cleveland Fed puts the chances slightly higher, at 6.19%.

But with short-term rates already so low, long-term rates would have to go very close to zero for the yield curve to invert. Since that seems highly unlikely, the inversion indicator may be broken.

Some investors and analysts believe the slope remains positive only because of extensive central bank easing, which tends to push harder on short-term rates.

Mark Yusko, chief executive of Morgan Creek Capital Management, said last week that he believes the curve would already be inverted if not for the relentless pressure on short-term rates.

"Historically, it has been a predictor," said Gemma Wright-Casparius, a senior portfolio manager at Vanguard. "We are looking to other factors at this juncture."

Not everyone is convinced. Banks including Royal Bank of Canada and UBS Group AG have pointed to the yield curve amid the market turbulence to dispel fears of a coming recession.

Japan's experience with ultralow rates may be instructive. During each of its past four recessions, the yield curve didn't invert. Analysts at Deutsche Bank AG argue this indicates the yield curve won't invert when short-term rates are below 1%.

But even if the curve won't invert before a recession, differences between long and short interest rates still could help predict economic conditions. For example, the U.S. yield curve has been flattening in a similar manner to Japan's before it entered recent recessions, said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.

"To me, the yield curve is sending the unmistakable signal that growth is not getting better," he said.

(END) Dow Jones Newswires

February 06, 2016 05:44 ET (10:44 GMT)