By Richard Leong
(Reuters) - A swift steepening of the U.S. 2-year/10-year yield curve after it inverted last week may have given investors hope that the United States can escape recession. They should probably take a breath.
History indicates that the reprieve may be brief, before a more sustained, severe flip occurs.
A catalyst for another inversion might happen later this week if the Federal Reserve's minutes on its July 30-31 meeting on Wednesday or Fed Chairman Jerome Powell's speech on Friday at the Jackson Hole economic conference were to suggest U.S. policy-makers are not fully on board for an all-out rate-cutting mode, which could drive short-term rates higher and flatten the curve. For an explainer on the yield curve:
The yields on 2-year and 10-year Treasury notes inverted for the first time since 2007 last week, rattling investors who saw this as an omen that a U.S. recession is coming.
While the 2-and-10-year inversion has gone away for now, the previous three bouts of inversion on this part of the yield curve have shown a pattern: a steepen and then return to a more sustained or deeper inversion more than once before a recession hits.
The inversion between three-month Treasury bill rate and 10-year Treasury yield - which economists and some Fed economists believe is a more reliable recession indicator - has been in place since May. That curve inverted in March, steepened in April and then inverted again.
While the stock market reacted with fear after the inversion, there was skepticism from some that a recession would necessarily follow. The yield curve retraced its inversion and stocks rebounded on Monday.
"We would caution against seeing the inversion of the yield curve as an infallible predictor of an economic contraction or a bear market," UBS Global Wealth Management's chief investment officer Mark Haefele said.
Currently, some investors said the latest episode of the inversion is overstating the chances of a recession. They argue the Fed's openness to lower borrowing costs would prolong the current economic expansion, which became the longest on record last month.
"We do not view the inversion of the yield curve as a recessionary signal, and see central banks' dovish pivot stretching the growth cycle," said BlackRock Investment Institute on Monday.
Here is how the curve has performed in recent years after an initial inversion:
In February 2006 when the 2-to-10-year part of the curve inverted, that lasted for about a month before 10-year yields rose above their two-year counterparts.
Then the inversion re-emerged about three months later and largely persisted into May 2007.
At the time, the Federal Reserve was at the tail end of a rate-hiking campaign that ultimately raised the federal funds rate to 5.25% in June 2006 from 1.25% in June 2004.
"Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain," Fed policy-makers said in a statement after their June 2006 meeting.
Some investors had downplayed the inversion as a harbinger of a looming economic downturn.
In mid-1998, the 2-to-10-year part of the yield curve inverted briefly before a more sustained inversion took place in 2000 while the dotcom stock bubble was imploding which sent the economy into a recession.
From December 1988 to May 1990, the 2-to-10-year part of yield curve inverted on five separate occasions before a recession June 1990.
In the late 1970s to the early 1980s, curve inversion was a mainstay as then Fed Chairman Paul Volcker sought to combat double-digit inflation by tightening money supply, a move that propelled the federal funds rate above 17% in 1980.
(Reporting by Richard Leong; editing by Megan Davies and Lisa Shumaker)