One of the oldest jokes in economics is that “the stock market has predicted nine of the last five recessions.” That’s a reference to the fact that stock markets tend to decline about six months before a recession, but they also decline at times when there is no recession. This makes the stock market an unreliable predictor of recessions even though stocks actually do signal recessions consistently.

However, certain indicators have much better track records at predicting recessions than others. One of the most accurate is an inverted yield curve. The yield curve is just a graphical representation of interest rates at different maturities. Generally the yield curve is upward sloping because longer maturities have higher interest rates. That makes sense because when you buy a 30-year bond, you’re taking more risk than when you buy a two-year note (because of inflation and risk of default), so investors want to get compensated for the extra risk with a higher interest rate.

An inverted yield curve is when the curve slopes downward. This means that long-term interest rates are lower than short-term interest rates. That’s a very bad sign. In an inverted yield curve situation, short-term rates are higher because the Fed is raising interest rates and tightening monetary policy by reducing its balance sheet. But, long-term rates are low because the market believes the Fed is tightening too much and the economy is headed for a recession.

If a recession is coming next year, you might be glad to take a lower interest rate on a two-year Treasury note because that rate will look attractive when unemployment goes up and other rates head back towards zero. If rates head down next year or the year after, you can also pick up a nice capital gain on your Treasury notes; that’s another reason to accept a lower rate today.

This article reports that a small section of a specific yield curve (the overnight indexed swap rate or “OIS) has now inverted. The OIS is not the same as the Treasury yield curve (but, it’s similar) and it’s only one small part of the yield curve.

So, it’s not time to sound sirens and ring alarms quite yet. But, it is a troubling sign for future growth and should be watched closely.

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