The bond market is nearing a point where it may signal that the Federal Reserve’s series of interest-rate hikes is shifting the narrative toward the risk of a stalling US economy.
The additional yield investors require to hold 10-year Treasuries compared to two-year notes narrowed to just 17 basis points last week, marking the tightest spread since early 2025. This flattening of the yield curve increases the likelihood that 10-year yields will soon fall below shorter-term maturities, a phenomenon known as a curve inversion.
Historically, an inverted curve has served as a potent indicator: it has preceded each of the last eight recessions dating back to the 1960s, though its predictive accuracy faltered earlier this decade. Essentially, it is the bond market’s way of indicating that investors believe the Fed is raising rates high enough to stifle economic growth in its pursuit of lower inflation. Such an outcome would have significant consequences for rate hike in three years this month and signaled that further increases are likely. It also highlights how a hawkish Fed is shifting the balance of risks following a bond sell-off that was driven by rising price pressures amid robust growth.
“Seeing the two- and 10-year curve invert or flatten dramatically calls into question the idea that the economy is very strong and that is part of what’s being priced into the bond market,” said Zach Griffiths, the head of investment-grade and macro strategy at the research firm CreditSights.
An inversion would reverse the global normalization of yield curves observed since 2024. Bond investors typically demand higher returns, or yields, to compensate for the uncertainty of locking away capital for longer durations. Consequently, yield curves generally maintain an upward slope.
As recently as last month, that was the trajectory for the curve as long-dated yields climbed, partly due to concerns that the Fed’s inflation-fighting credibility was weakening under chairman Kevin Warsh. However, following the central bank’s September hike, shorter-term maturities have driven yields higher. Traders are currently pricing in the equivalent of at least three quarter-point Fed hikes over the coming year.
Some analysts do not anticipate an imminent inversion, as the significant number of hikes already priced into the market makes it more difficult for short-term rates to rise further relative to longer-dated yields.
“The market has already pencilled in significant Fed rate hikes, which have pushed the curve sharply flatter in recent weeks,” said Gennadiy Goldberg, the head of US interest-rates strategy at TD Securities. “This makes us believe the 2s10s curve is likely to move steeper in the weeks ahead.”
It is also difficult to imagine the economy weakening substantially at this moment. According to the latest Bloomberg monthly survey, economists have recently upgraded their forecasts for US third-quarter growth due to stronger demand.
‘Rising odds’
However, others argue that the flattening trend has momentum. Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle, stated he is positioning for an inversion of the two- to 10-year and five- to 30-year curves over the next six months as the Fed tightens policy to cool the economy and inflation.
“The best indication that monetary policy is getting tighter is a flattening and eventually an inversion of the yield curve,” he said.
In Asian trading on Monday, the two- and 10-year notes yielded approximately 4.90% and 5.21%, respectively. The 10-year yield, a primary global bond benchmark, is hovering near its highest level since 2007.
When the curve inverts, it often reflects anxiety regarding growth prospects, as rate hikes are intended to combat inflation by dampening loan demand. A deceleration in growth could eventually create conditions for the Fed to cut rates, causing long-term yields to decline relative to shorter-term ones.
Data compiled by Bloomberg indicates that since 1978, the two- and 10-year curve has inverted an average of 15 months before the onset of a recession, with a lag ranging from six months to two years.
The predictive reliability of the curve, however, has faced increased scrutiny in recent years. Various US curves inverted in 2022, with most economists forecasting a recession within 12 months. That downturn never occurred, as the economy proved largely resilient against the Fed’s 2022-2023 tightening cycle, a regional banking crisis, a global trade war, and this year’s spike in energy costs.
While the two- to 10-year curve is the most commonly cited among bond investors, policymakers looking for recession signals also monitor others tied to three-month lending rates. The spread between three-month Treasury yields and 10-year rates remains relatively wide.
Market ripples
The recent flattening of two- to 10-year Treasuries has penalized bond investors who entered the year positioned for a steeper curve. The effects are also spreading through US equities, particularly bank stocks. Because banks typically borrow at short-term rates and lend at longer-term rates, a narrower spread between the two reduces their net interest margins.
The KBW Bank Index, which tracks the shares of major lenders, entered a technical correction last week, reflecting a 10% decline from its recent peaks.
The shift toward inversion highlights the potential for a complete transformation in the economic outlook since the US war with Iran began in February. Prior to that, traders were betting on a series of rate cuts that would lower short-term yields, rather than the hikes they are anticipating today.
An inversion “would be a sign that the Fed is making a policy mistake”, said Jamie Patton, a co-head of global rates at the TCW Group. “It’s raising rates too much, and it’s going to have to cut them hard in the future. So to us, inverted yield curves are not healthy signals for the macro economy.”
