Amada Agati:  

There's been a lot of attention on the yield curve lately, so in this edition of "#AddingAlpha," we wanted to set the record straight on what's going on with the yield curve and why it matters for investors.

In business cycle analysis, a leading indicator of recessions is, in fact, the shape of the yield curve.

When portions invert or look kinked, instead of a smooth, upward-sloping curve, that's usually the bond market signaling some cause for concern in the economic outlook.

An inverted yield curve means longer-dated maturities are yielding less than shorter-dated maturities, and that's really counterintuitive.

Investors expect to get paid in the form of higher interest rates over longer horizons.

So let's zoom in and look a little closer at two sections of the yield curve for potential clues and signals about the path forward -- the 2-year to 10-year yield spread and the 3-month yield to the 10-year yield.

These two spreads have historically been highly correlated with each other, to the tune of 0.90, which means they tend to move in similar patterns over time but not perfectly in sync with each other.

Take a look at this chart, though, comparing the paths of these two spreads.

They're moving in sharply opposite directions lately, and as a result, they're definitely giving us very different signals in terms of the path forward.

So, perhaps it's not entirely surprising that the "R" word -- that is, recession -- is coming up more and more frequently lately, especially with all of the volatility in the market we're seeing, the Fed signaling seven more rate hikes to go this year, and now this unusual shape of the yield curve forming.

Notably, though, the one spread that tends to be the primary "canary in the coal mine" signal for a recession is actually the 3-month to the 10-year yield spread, which tends to be in pretty good shape, as of this recording.

The 3-month to 10-year yield, the blue line on this chart, is sitting at about 188 basis points in positive territory and far from inverted.

It's also normally shaped, and so from our perspective, this is the market signaling there's still ample runway left in this cycle despite it being a slower pace of growth ahead.

However, the 2s to 10s, the line in orange on this chart, is now sitting at -5 basis points, meaning the yield on the 2-year is actually above the 10-year Treasury and has inverted, as of this recording.

This portion of the curve is really telling us a decidedly different story.

It's the market basically giving the Fed an "F" on its monetary policy report card, signaling the Fed is too far behind and will be too aggressive in playing catch-up, that they'll end up tightening policy so much that it may break the cycle and ultimately tip us into recession.

It's this portion of the curve that's saying, "Investors, beware!"

While we're obviously watching this signal very, very closely, so is the Fed.

So we think calls for recession based solely on the spread between the 2-year and the 10-year yield is too premature.

It's a useful tool in the toolbox for our business cycle analysis, but it's not a perfect indicator.

Even when it is correct in forecasting a recession, the market peak is typically well beyond a year after the initial yield curve inversion occurs.

Markets are now pricing in a very high probability of a rate hike at the next Fed meeting in May.

Translation -- a 50-basis-point increase to 1% is a foregone conclusion.

We don't think that's necessarily guaranteed because of this dynamic in play with the yield curve.

Markets haven't given the Fed hardly any headroom to tighten policy and raise interest rates.

At the end of the day, financial conditions have tightened lately, yes.

After all, that is the point, since we were at all-time lows last year, but we're still in very supportive territory for markets and the economy.