Some investors fear negative-yielding debt more than the inverted yield curve. Here's why.

Reuters/Brendan McDermid

• The yield curve - a trusted recession indicator throughout history - has been inverted for months.
• But some investors interviewed by Markets Insider say they're more scared of what the growing mountain of negative-yielding debt may mean for the market's health.
• Negative rates are top of mind for investors as the Fed signals more rate cuts ahead. They're already a reality in Europe and Japan, which has pulled down yields on US Treasurys.
• With rates so low, the Fed has less room to further stimulate the economy in the event the US does go into a recession.
• Read more on Markets Insider.

The yield curve has long been viewed as a reliable indicator for a looming recession. After all, an inversion of the curve has preceded every US recession since 1950.

But even though parts of the curve have been inverted for months, not all experts see it as the biggest issue. That includes Lisa Shalett, the chief investment officer at Morgan Stanley Wealth Management.

"That's just what happens at the end of a business cycle," she told Markets Insider in an interview. "What bothers me is the level of interest rates."

Ed Yardeni holds a similar point of view. In recent meetings with clients, the chief investment strategist at Yardeni Research also noticed more fear around negative interest rates than the yield curve.

"Most of them believe that the US economy can continue to grow for the foreseeable future. So they aren't freaking out about the recent inversion of the yield curve," Yardeni wrote in a note. "However, they are somewhat anxious about the prospect of negative interest rates in the US, though they think it is a remote possibility."

It's a popular topic of discussion because there are mounting expectations that negative rates - now a reality in Europe and Japan - could happen in the US. It's a threat that's been further exacerbated by the Federal Reserve's continued willingness to cut interest rates.

The main threat of negative-yielding debt is what it could do to the US economy if a recession does hit. While many investors agree that a full-blown meltdown is not an imminent threat, the global economy is declining and a few US indicators have begun to show slowing as well.

The unfortunate reality of the situation is this: If a recession hits when interest rates are already so low, further monetary-policy efforts will be less effective because there will simply be less opportunity for the central bank to maneuver.

Less room to save the US economy

Bonds have rallied since the Fed's dovish pivot at the end of 2018 and continue to price in further rate cuts over the next year. This is significant because as quality-hungry investors flee bond yields lower, real yields - or how much an investor gets back after subtracting inflation - decline as well.

This is a problem because if the US does enter a recession, the Fed will have little room to cut further to get the economy running again.

"We're running out of room to cut," Shalett said. "We've run out of room for the bad scenario. We have no insurance." At that point, the Fed will likely use other tools at its disposal, such as quantitative easing, to inject more money into the US economy to stimulate it.

If the US economy does slow further and the Fed needs to cut, negative yields "could be the direction in which we're heading," Yardeni told Markets Insider in an interview.

Pushing investors towards higher risk assets

Lower yields on US treasury bonds - long considered safe assets - create a situation where inherently riskier stocks look increasingly appealing to investors. But as those risky positions swell, it also creates more potentially devastating downside risk for investors - even if they're purchasing so-called bond proxies.

"Slow growth is not a bad environment for dividend-yielding stocks," Yardeni said. But the catch is that if a recession does hit, "you don't want to be running into stocks whether they have yielding dividends or not," he said.

Negative interest rates "give off some really bad karma," Yardeni continued, saying it creates the perception that conditions are so weak that deflation could result. That's an issue because if prices are heading lower, consumers are more likely to hold onto their money than spend it, furthering an economic slowdown.

The lower bound

With all of that established, it's not a given that the US will see negative interest rates.

For one, there are other things the Fed would likely do before cutting interest rates below zero, which would be a "last resort" and "an admission of defeat," Jay Sommariva, vice president and director of fixed income at Fort Pitt Capital Group, told Markets Insider.

But there's still worry that as the Fed eases and the federal funds rate gets closer to zero, it could actually be a bad thing for the economy.

"When you get to that lower bound, when you get close to zero, the question is whether lower interest rates are in fact stimulative or lower interest rates are actually contractionary," Shalett said.

When interest rates get close to zero - or go below it- people who live on fixed income have to save more, not spend more. This lack of spending can actually cause the economy to contract, which is what has happened in Japan. When the consumer isn't spending and interest rates are negative, there's little else that can be done to spur the economy again.

"The tool you were using to cure the disease actually cause your disease to get worse," Shalett said.