A key recession indicator is flashing yellow again - but there's one reason why this time could be different

• The gap between long- and short-term Treasury yields is now at its narrowest level since the financial crisis.
• In the past, yield curve inversions where long-term rates actually slip below short-term ones have been reliable predictors of recessions.
• Wall Street and Fed officials are worried about the prospect of an inversion - but caution that the Fed's expanded balance sheet makes the flattening trend less worrisome.

There's an important recession indicator flashing yellow in the US economy, and it's catching the attention of Federal Reserve officials and Wall Street investors.

Some market analysts say it's important not to overreact to the trend of a flattening yield curve - a narrowing of long-term and short-term Treasury yields - just yet. They say the Fed's expanded balance sheet helps explain some of the persistently low spread, making its decline less alarming.

Still, the gap between 10- and 2-year Treasury yields has now fallen to less than half a percentage point - its lowest level since 2007.

Traders and Fed policymakers worry that as the Fed continues raising interest rates, which it intends to do at least two more times this year, it could risk an inversion of the curve - where long-term yields would actually fall beneath their short-term counterparts.

Because this suggests investors expect declining investment returns over time, inverted yield curves are considered a highly reliable predictor of recessions.

"Since 1960, the US economy has undergone eight recessions, meaning that the country has been in recession 14.2% of the time," Juan Carlos Berganza and Alberto Fuertes wrote in a new paper published by the Bank of Spain.

"In all cases, the economy's entry into recession was preceded by a yield curve negative slope situation, some months before."

All upside down

Still, the authors caution the Fed's vastly expanded balance sheet, which at $4.4 trillion remains more than five times its pre-crisis levels despite the recent start of a gradual wind down, changes how investors should think about the yield curve.

"The factors that have influenced the current flattening are different from those of past periods, such that the inversion of the curve might not be anticipating a recession," they argue.

"In the current setting, expectations of increases in the policy interest rate remain in place, while term premia are very low, especially those for the longer-dated maturities, this being a considerable differential factor compared with the past," the authors add.

Still, a yield curve inversion would shake confidence and "pose a further communication challenge to the Federal Reserve" as it tightens monetary policy.

Market strategists at UBS tend to agree that flattening concerns are overstated.

They wrote in a research note that "due to QE [quantitative easing or bond buys], the curve is not as flat as it appears to be optically."

The strategists added, "Adjusting the US curve for the drop in term premia suggests that-relative to history-the steepness of the curve is quite 'average' and definitely not excessively flat."

Nevertheless, it's important to remember that in the run-up to the Great Recession, the yield curve's inversion was also dismissed as being "different this time." That judgment proved drastically wrong.

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