Why the Yield Curve Just (Briefly) Uninverted

The Treasury yield curve, one of the market’s most reliable recession indicators, briefly uninverted for the first time in more than two years on Monday morning as equities sold off amid concerns about a slowing U.S. economy. 

The spread between 2-year and 10-year yields, a common proxy for the Treasury yield curve, briefly dipped to -0.01 points in early trading Monday, marking the first time that the 10-year yield has exceeded the 2-year since July 2022. 

What Does the Yield Curve Represent?

The yield on 10-year Treasury notes is normally greater than on 2-year notes because longer-duration debt comes with more risk. For investors purchasing Treasury debt, those risks are primarily related to short-term interest rates.

The yield on a Treasury bond generally reflects what investors expect from interest rates over the bond’s lifetime. When the yield on 2-year Treasurys exceeds that of 10-year notes, that is usually because investors see the Federal Reserve lowering interest rates to stimulate a faltering economy. This is why the inverted yield curve has developed a reputation as a reliable recession indicator.

The yield curve has inverted within two years of the beginning of each of the last six U.S. recessions—though its inversion before the March 2020 recession sparked by COVID-19 is widely considered anomalous.

Today’s Inversion the Longest on Record

The current yield curve inversion began in July 2022 shortly after the Federal Reserve started raising interest rates to combat surging inflation.  

The curve reached peak inversion (1.1 percentage points) in July 2023 shortly before the Fed hiked interest rates for the last time in this tightening cycle. After that hike, the spread gradually narrowed as inflation readings improved and markets were assured the Fed wouldn’t raise rates higher. 

Throughout much of this year, with inflation slowly ticking lower and economic data remaining relatively strong, the spread had fluctuated between 0.2 and 0.5 percentage points. 

In March, the present inversion became the longest on record. Yet a recession had failed to materialize, leading many to question the yield curve’s predictive powers. 

Recent economic data, however, has shaken confidence in the economy’s footing and revived recession fears. After a soft June inflation report in mid-July and data from last week pointing to a weakening labor market, investors are increasingly convinced the Federal Reserve will cut interest rates in September. 

Now, the question on Wall Street isn’t whether the Fed will cut rates in September; it’s how much it will cut rates. Last Monday, traders were pricing in an 88% chance of a 25-basis-point (bps) cut and an 11% chance of a 50-bps cut in September, according to CME’s FedWatch tool, which quantifies the market’s interest-rate expectations based on federal funds rate futures trading data. Today, investors see a 15.5% chance of a 25-bps cut, and an 84.5% chance of a 50-bps cut.