THE stock market has correctly forecast nine of the past three recessions, economists like to joke. It’s a gentle put-down to the idea that financial markets have any genuine predictive power with respect to the so-called real economy.

It certainly holds up as far as volatile stock markets go, but it ought to be a different story when it comes to the bond markets.

The prices of fixed-income assets are, after all, moved much more directly by variables such as short-term interest rates and hard economic and inflation data. We should not be surprised to find some link between bond yields and the business cycle.

Indeed, history certainly suggests that there is a reasonably reliable, forward-pointing connection. It was this historically observed relationship that produced some serious jitters in American financial markets last week. The culprit was the long-awaited inversion of the yield curve.

The yield curve maps interest rates on bonds at different maturities. A normal yield curve is upward sloping from left to right. This is considered normal because investors usually demand a higher annual interest rate for the uncertainty of holding longer-dated paper. How steep the yield curve is depends on a number of factors, including the degree of that uncertainty in the economic outlook, the scale of the inflationary risks and so forth.

Occasionally, however, the curve inverts, meaning that shorter-dated maturities actually yield more than longer- dated ones. Traders have noted that, in the past 50 years or so, when this has happened it has tended to be the precursor to a recession.

If you think about it, it makes sense. The inverted curve suggests that either investors think that short-term interest rates will have to fall at some point in the near future, a sure sign of an economic slowdown, or alternatively they might be pushing long yields down because of a sharp loss of confidence in the economic outlook. Either way, a recession is a strong probability.

So when the two-year Treasury note last week yielded slightly more than the ten-year bond, a number of market participants (who had not, presumably, been paying much attention in recent weeks as this convergence approached) ran scared, shouting “The Curve is Inverting!” – the financial equivalent of “The Sky is Falling!” — and sold.

The last time that inversion occurred was in early 2000 and within a year the economy had entered its first recession in more than a decade.

Indeed, only twice in the recent past has the inversion of the yield curve given a false positive indicator of recession. In the summer of 1998 financial markets went haywire after the Russian debt default and, amid a general meltdown in confidence following the Asian financial crisis, long yields plummeted below short rates.

Thirty years earlier similar uncertainties pushed the long rates temporarily below the short end.

So does last week’s inversion — which, though it was quickly reversed, seems almost certain to be a fact of life in the early part of this year — mean that a recession is imminent? Or is it another example of a rare false alarm? It looks very much like the latter. For one thing, long-term interest rates have been held low for some time now by a number of factors that have little to do with investors’ concerns about growth.

A flood of global savings looking for a profitable and safe home — from overseas investors as well as from increasingly risk-averse US pension funds — has been pouring into ten-year Treasury bonds for the past couple of years, keeping yields unusually low for this stage of the economic cycle.

But there is an even better reason for thinking that the current inversion will not result in a recession.

In the past, when short rates have gone higher than long ones, it was usually because they had been pushed there by an aggressive Federal Reserve, raising rates to stamp out inflation. It habitually produced a recession in the process.

This time the Fed funds rate is only 4.25 per cent, and though it will probably go a little higher in the coming months, it is unlikely to go much further. In inflation-adjusted terms, this amounts to real short rates of a little over 2 per cent.

In the past, when the yield curve has inverted, real short-term rates have been much higher. In 2000, for example, the Fed funds rate stood at 6.5 per cent, more than 4.5 per cent in real terms. That is a recession-inducing squeeze; 2 per cent real rates are not.

The fact is, as 2006 begins, we are in uncharted waters. The Fed is nearing the top of its interest cycle, but with rates much lower than where they usually are at this stage. At the same time, powerful demand is keeping long rates much lower than where they would normally be.

There is good news and bad news to being in uncharted waters. The good news is there’s no reason to use the old financial charts that seem to be telling us we’re headed for a recession. The bad news is no one really has a very good idea where on earth we will go from here.

gerard.baker@thetimes.co.uk

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