In the Markets Now: Faulty Signals

With so much information available at the click of a button, investors often fall back on key indicators and heuristics to signal important market shifts. But can these indicators be relied on in today’s world?

What Happened to The Yield Curve Recession Signal?

Seeking out simplicity is a natural reaction to a complex world – after all, Occam’s razor tends to be pretty darn reliable. However, in looking for simple explanations we often miss the forest for the trees. This is an ever-present phenomenon in financial markets, where there are simply too many moving parts to rely on any single indicator to properly tell the full story.

Consider the economic roller coaster of the last several years. In 2022, inflation spiked to its highest level in four decades and the Federal Reserve raised interest rates by 4.25 percentage points in a scant 9 months. Concurrently, the Treasury yield curve flipped from normal to inverted, setting off a well-known recession signal. (As background, investors typically demand higher yields when investing their money for longer periods of time, so a “normal” yield curve exists when long-term yields are higher than short-term yields. An “inverted” curve flips this relationship, and broadly signals that investors expect that the Fed raising interest rates in the present will force them to cut rates in the future – typically in response to economic weakness). True to its reputation, yield curve inversion has been quite successful in predicting recession – occurring before each downturn since the 1970s – and is now one of the more widely-hailed indicators in the investing world.

Therefore, when the yield curve inverted in 2022 (with stocks plummeting and inflation soaring), recession expectations spiked. In fact, in 4Q 2022, the Philly Fed’s Survey of Professional Forecasters found that expectations for a near-term recession were at their highest since (at least) the 1960s. And yet, a recession did not materialize. Quite the opposite in fact: across 2023-24, the U.S. added 5 million jobs, the S&P 500 rose 58%, and U.S. economic output rose in every quarter. So, what gives?

For one, any single data point will always struggle to tell the full story, even more so given the increasingly interconnected nature of the global economy. Further, the unprecedented nature of both the Covid-19 pandemic and policy response rendered many of the previously relied-on forecasting tools somewhat ineffective. The yield curve does incorporate how investors expect things to play out (reflecting Treasury bond buying/selling via yields), but forecasters were unable to get a firm grip on the many downstream implications of the trillions in fiscal stimulus and massive changes to the U.S. economy from the pandemic itself.

Then there’s also the sample size problem. While the yield curve has rightly “predicted” the last eight recessions, eight is still a very small number in the grand scheme of things. It would be unfair to call the indicator a coincidence – a number of rigorous academic studies have noted its value in forecasting – but it also takes credit for predicting the March 2020 recession that was clearly a product of the pandemic (not Federal Reserve action). Most quality financial data is only decades old – a blink of an eye in terms of human history – and things that look like pattern may end up being more noise than news once additional facts are collected. At a minimum, the certainty with which any of these indicators are discussed should be taken with a grain of salt.

In the end, the lesson here is not to discredit popular indicators – the yield curve still holds plenty of value – but rather to show that markets are complex beasts that require many inputs just to understand, much less forecast. While many spend their lives searching for the magic number that will solve the investing game (from the CAPE ratio to the Buffett Indicator to the Death Cross), the investor comfortable in a world of gray is better positioned to see the full picture, especially in and around economic turmoil. And, as ever, a long-term focus and diversified approach requires no silver bullet to reach investing goals.

Disclosures

This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. Market and economic statistics in this piece come from data provider FactSet.

This report does not provide recipients with information or advice that is sufficient on which to base an investment decision.  This report does not take into account the specific investment objectives, financial situation, or need of any particular client and may not be suitable for all types of investors. Recipients should not consider the contents of this report as a single factor in making an investment decision. Additional fundamental and other analyses would be required to make an investment decision about any individual security identified in this report.

For investment advice specific to your situation, or for additional information, please contact your Baird Financial Advisor and/or your tax or legal advisor.

Fixed income yield and equity multiples do not correlate and while they can be used as a general comparison, the investments carry material differences in how they are structured and how they are valued. Both carry unique risks that the other may not.

Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index.

Copyright 2025 Robert W. Baird & Co. Incorporated.

Other Disclosures

UK disclosure requirements for the purpose of distributing this research into the UK and other countries for which Robert W. Baird Limited holds an ISD passport.

This report is for distribution into the United Kingdom only to persons who fall within Article 19 or Article 49(2) of the Financial Services and Markets Act 2000 (financial promotion) order 2001 being persons who are investment professionals and may not be distributed to private clients.  Issued in the United Kingdom by Robert W. Baird Limited, which has an office at Finsbury Circus House, 15 Finsbury Circus, London EC2M 7EB, and is a company authorized and regulated by the Financial Conduct Authority.  For the purposes of the Financial Conduct Authority requirements, this investment research report is classified as objective. 

Robert W. Baird Limited ("RWBL") is exempt from the requirement to hold an Australian financial services license.  RWBL is regulated by the Financial Conduct Authority ("FCA") under UK laws and those laws may differ from Australian laws.  This document has been prepared in accordance with FCA requirements and not Australian laws.