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Inverted Yield Curve Is Waning as a Recession Gauge, BofA Says

(Bloomberg) -- An inverted Treasury yield curve is no longer a reliable signal of recession, and what matters more is the level of the curve, Bank of America economists Ethan Harris and Aditya Bhave said in a note.

The Federal Reserve is flirting with inversion probably because policy makers recognize its waning predictive power in a low-yield global environment, the economists said.

One widely-watched part of the curve inverted on March 22 for the first time since the financial crisis when a surge of bond buying, driven by lower growth projections and the prospect of Fed easing, upended the gap between three-month and 10-year yields. Meanwhile, the spread between 2-year and 10-year yields has stayed near some of the flattest levels in more than a decade since December.

In fact, the Fed has the power to “prevent or quickly undo” an unwanted inversion, the BofA economists said. With central banks operating on both ends of the curve, “the level of the curve matters more than the slope,” they said.

The Fed “is not sleep-walking over a cliff” and “has concluded that an inverted curve is not what it used to be and never was the sole relevant financial indicator,” Harris and Bhave said.

The two-year to 10-year spread has inverted before each of the past five recessions, except for one false signal in 1998. The curve typically turns negative late in the business cycle when policy makers have overshot the neutral policy rate to slow above-target inflation.

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