Never before has Wall Street's favorite 'recession indicator' sounded the alarm for so long

For more than 200 days, the Treasury market has been flashing an obscure warning signal known as an inverted yield curve—the longest on record.

In short, a yield curve inverts when short-term interest rates exceed long-term interest rates. Although not widely recognized beyond financial circles, this financial "quirk" carries implications for all Americans.

For starters, it directly, and indirectly, affects everything from consumer credit to bonds and stocks—the core of almost every 401(k).

In case of an inverted yield curve, for example, anyone with an adjustable-rate mortgage or any line of credit sees their payments rise. That's because shorter-term loans like credit cards and auto loans are usually tied to rates on shorter-term Treasury bills.

Finally, an inverted yield curve serves as Wall Street's key canary in the coal mine. It signals that the market is gearing up for a recession.

The impact of an inverted yield curve on people's nest eggs cannot be overstated. But economists don’t always do a good job explaining why it happens.

How does yield curve inversion happen?

The yield curve is an easy way to visualize interest rates on bonds with various maturities.

Under normal circumstances, the line on the chart slopes up and to the right. It indicates lower interest rates for shorter-term bonds and higher interest rates for Treasuries with a longer time to maturity.

This makes sense; after all, time is money. For example, investors expect to receive a higher interest rate for holding a 10-year bond than for holding one with a three-month maturity.

But sometimes, the curve flips as interest rates on short-term bonds exceed rates on long-term bonds. Part or all of the yield curve “inverts,” with the line sloping downward.

This inversion happens because investors buy longer-term bonds at a much faster clip than short-term bonds, driving up their prices. And as bond prices rise, their yields fall (and vice versa).

So, why are investors suddenly snatching up long-term bonds? Because they’re worried about the economy and would much rather park their money in “safe” long-term assets.

“Traditionally, government bonds have been a safe haven,” says Sam Stovall, chief investment strategist at financial research firm CFRA. “The U.S. government doesn’t go out of business, but shaky companies do. Even pretty stable companies experience challenging times during recessions.”

There are all kinds of yield curve inversions, but the most closely watched is the spread between the 10-year Treasury and 2-year Treasury.

When the shorter rate exceeds the longer one, history points to rough times ahead. But is the yield curve inversion still a valid recession indicator?

A distorted signal?

According to the San Francisco Fed, an inverted yield curve has foreshadowed all ten U.S. recessions since 1955. When the yield on the 2-year exceeds the 10-year, it takes an average of 15 months to enter a downturn.

Despite the perfect prediction record, economists think the Fed’s massive rate-hike campaign has distorted the bond market’s recession signal.

“This cycle has been an odd one, because when the yield curve originally inverted, most expected we were on the verge of a downturn,” Phillip Wool, head of research at Rayliant Global Advisors, told Bloomberg.

“The surprising strength of the U.S. economy makes the odds of a soft landing much better than they were a year ago,” he said.

The jury is still out about where the economy is headed. For the average American household, the more pressing question is how much higher interest rates can really go.

Americans are maxing out on credit cards and personal lines of credit—and paying exorbitant interest rates. They also can’t afford to extract equity from their home because of the massive refinancing costs.

The average person isn’t thinking about the yield curve, but it nevertheless impacts them.