Strange things are afoot in the bond market.

Traders are placing bets on whether the Federal Reserve will soon be forced into reverse by a slowing economy and swooning stock market. That has led to a lot of weirdness.

Perhaps the most shocking example is that the five-year Treasury now yields less than the top of the Fed’s 2.25%-2.5% target range for the federal-funds rate that banks pay for overnight borrowing. In the Treasury bill market, investors now earn more on a bill maturing in October than they do on one at the end of 2025.

Bondholders want safe assets for the long run and are prepared to pay up for them.

The natural interpretation of this is a depressing one: Bondholders think the Fed is about to make a mistake of historic proportions, raising interest rates into a weak economy and being forced to backtrack within a year. The yield curve—a chart of yields against bond maturities—on one measure is close to predicting a recession. That is a view shared by company finance chiefs, who are prepping for a shrinking economy by the end of 2020.


The bond market is regarded by many investors as less flighty than the stock market and more reliable in its predictions. But history shows it is still prone to error and overreaction.

After starting well, 2018 turned out to be a horrible year for markets. Will 2019 be any better? WSJ's James Mackintosh and Riva Gold chart the outlook.

There are three decent recent parallels where five-year bonds dropped below the fed-funds target.

Just like today, the 1995 inversion of parts of the yield curve was due to falling five-year yields, as investors realized that they were wrong to expect the Fed’s aggressive rate-raising of 1994 to continue as inflation slowed. The Fed ended up cutting rates three times, while the economy and markets steadied and turned into the tech boom. Recession didn’t hit for another six years.

However, in 1994-95 the S&P 500 was much more stable than it is today, avoiding the 20% drop it had from last year’s September intraday peak to the close on Christmas Eve. The yield curve had flattened in 1995 but, unlike today, it still mostly sloped upward.


Perhaps a better parallel is 1998, when the emerging-markets meltdown finally hit Wall Street by blowing up giant hedge fund Long Term Capital Management. Like today, the one-year Treasury yield was higher than the five-year, and stocks were—using intraday prices—in a bear market.

In 1998, the Fed responded promptly, organizing a Wall Street rescue and cutting rates. The continuing tech boom turned into a bubble that burst 18 months later with catastrophic consequences for dot-com shareholders but little damage to the economy.

The third example turned out much, much worse. In 2006, the yield curve fully inverted, with 10-year yields below all shorter maturities, as house prices stalled. The bond market was—correctly—forecasting recession and a series of a rate cuts. Still, stocks had time for a final end-of-cycle boom, gaining more than a quarter before the bust and Great Recession of 2007-09 crippled the economy.

Past may be prologue, but none of these parallels is perfect. In 1995, the stock market was rising fast by the time bond yields dropped below the fed-funds rate, as investors realized the Fed was about to reverse its 1994 mistake. Today, fed-funds futures are priced for no change in rates this year, although there has been a huge shift since the start of last month, from a 73% chance of rates rising to only 8%, with a 30% chance of a cut, according to CME Group.


In 1998, there was a clear event, the Russian default and LTCM implosion, that prompted both the yield drop and the Fed response. There are several potential causes for today’s global economic weakness, making it harder to assess how bad it is.

In 2006, the inversion of the curve was due to the Fed’s raising rates, not due to longer-dated bond yields falling, as it is today. Unlike then, the yield curve isn’t predicting recession on the standard academic measure, which waits for the 10-year yield to be below the three-month yield for a sustained period. But the 10-year at 2.55% on Thursday is getting close to the one-year’s 2.51% and isn’t far above the 2.38% on the two-year Treasury that investors tend to prefer for comparison, according to Refinitiv data. Recessions have usually followed in the U.S. when the curve inverts, but not always, and they sometimes take a long time to arrive. This is art, not science.

Skeptical investors might reasonably conclude that no one has a clue, given the huge daily swings in stocks and, this week, currencies. Investors are desperately grabbing at every piece of evidence as they try to decide whether global weakness will persist, whether it will drag down the U.S. economy, and how long the Fed will wait before responding. Strange days indeed.

Write to James Mackintosh at James.Mackintosh@wsj.com