In other countries, the curve is such a reliable indicator of a downturn that the Cleveland Federal Reserve maintains a recession probability measure based on short- and long-term government bond prices. The bank writes that bond yields “predict whether future GDP growth will be above or below average," although it acknowledges that the measure "does not do so well in predicting an actual number, especially in the case of recessions.” In other words, bond yields provide good evidence about the direction of economic growth, if not specific levels.

One needs to be careful about drawing similar conclusions in China, however. For one thing, the central government bond market remains relatively small, while the remaining bond market is overwhelmingly short-term. Government bonds account for roughly a third of the total market, and of those, only a third mature after 2027. These factors, as well as the relative immaturity of the Chinese bond market, defy any strong comparisons to other countries.

What else might explain China's inverted curve, if not an impending recession? For much of this year, banking regulators have focused on addressing financial risks, primarily by reducing leverage. Data indicates that downward pressure on new credit growth was strongest in March and April.

The crackdown has pushed up short-term interest rates and pushed down the prices of financial assets such as stocks, bonds and commodities. Officials are nervous; they want to restrain leverage growth without triggering a fire sale of assets. With surprising regularity, Chinese politicians and regulators have come out and publicly reaffirmed that the financial system remains sound, insisting investors need not fear an uncontrolled plunge in asset prices.

Meanwhile, short-term wealth-management funds hold large amounts of government and corporate bonds in levered fixed-income products. The government crackdown disproportionately impacts the yield curve on the short end of the term structure, pushing up yields in shorter maturities. The fact that long-term rates are more stable doesn't matter: Wealth-management products maturing every six months simply don't buy 30-year government bonds.

This matches closely what we see. Long-dated bond yields have risen much more slowly than the short-term debt yields since the beginning of 2017. For instance, spot yields on two-year government bonds have increased 80 basis points, while 10- and 50-year yields have increased only 54 and 31 basis points, respectively. The inversion in the Chinese bond market stems not from a major fall in long-term yields, but from a large increase in short-term yields.

This has important implications. Perhaps the central question among Chinese investors right now is how long regulators can sustain their game of chicken with levered investors. Thus far, the People's Bank of China has seemed willing to let short-term interest rates -- the primary borrowing tool of investors -- drift upward while providing just enough new liquidity to prevent a major selloff. Yet clearly, long-term investors remain unfazed.

This implies investors believe regulators will ease their deleveraging campaign, allowing short-term rates to come back down. This isn't a bad bet: Historically, while Chinese officials have talked tough about reining in financial risks, they've always blinked when their efforts seem to be threatening growth and asset prices.

If the government is to win its battle with the Chinese market, it needs to reset such expectations. It'll have to run a monetary policy that forces firms to allocate capital more efficiently, and avoid the temptation to revert to easy money flows.

So far, regulators seem to have accepted that asset prices will fall as financing options narrow. But there's more pain ahead: Some 11 percent of shares on Chinese stock markets are pledged for loans, and the profits of steel mills, say, are dependent on prices driven up by highly leveraged shadow banks. China may not be on the verge of recession. That hardly means the path forward is going to be easy.