Original author: Zhao Ying

Original source: Wall Street Journal

The U.S. Treasury yield curve is approaching the critical point of inversion, and the bond market is beginning to signal warnings that the Federal Reserve's continued interest rate hikes could drag down the economy.

Last week, the difference between the 10-year and 2-year U.S. Treasury yields narrowed to a minimum of 17 basis points, the smallest spread since early 2025, significantly intensifying the trend of curve flattening. This dynamic occurred after the Fed completed its first rate hike in three years this month and hinted at continued tightening thereafter, with the market currently pricing in at least three more 25 basis point rate hikes within the next year.

The inversion of the yield curve has historically preceded every recession since the 1960s, and if it materializes, it will have a broad impact on the U.S. stock market and the banking sector, which are currently near historical highs. Meanwhile, the KBW Bank Index has already fallen over 10% from recent highs, entering a technical correction.

Curve flattening accelerates, inversion risk rising

The 10-year U.S. Treasury yield is currently around 5.2%, while the 2-year yield is about 4.9%, with the spread between the two fluctuating within approximately 30 basis points, the narrowest level in recent years. The 10-year yield is currently near its highest point since 2007.

Following the Fed's rate hike this month, short-term yields have increased significantly faster than long-term yields, pushing the curve to continue flattening. This trend has led to substantial losses for bond investors who bet on a steepening curve at the beginning of the year.

Zach Griffiths, CreditSights' head of investment-grade and macro strategy, stated: “Seeing the 2-year and 10-year curve invert or significantly flatten will cause the market to question the judgment that the economy is very strong, which is exactly what the current bond market pricing reflects.”

Inversion signals historically strong warnings, but credibility weakened in recent years

The inversion of the yield curve is viewed as a collective statement from bond investors indicating excessive rate hikes by the Fed and a weakening economic outlook. According to Bloomberg data, since 1978, the 2-year and 10-year curve has inverted on average about 15 months before a recession begins, with a lag period ranging from 6 months to 2 years.

However, the predictive power of this indicator has faced increasing skepticism in recent years. In 2022, several yield curves in the U.S. inverted, with most economists predicting a recession would occur within 12 months, yet the recession never materialized—after experiencing the Fed's aggressive tightening from 2022 to 2023, a regional banking crisis, a global trade war, and surging energy prices this year, the U.S. economy has shown remarkable resilience.

It is worth noting that the recession signal more focused on by policymakers is the spread between the 3-month and 10-year U.S. Treasury yields, which remains relatively steep and has not issued clear warnings.

Is inversion imminent?

There is a significant divergence in the market regarding whether the curve will further head towards inversion.

Gennadiy Goldberg, head of U.S. interest rate strategy at TD Securities, believes the market has already priced in a large amount of rate hike expectations, leaving little room for further short-term rate increases. He expects the spread between the 2-year and 10-year yields to steepen over the next few weeks. He stated: “The market has fully accounted for substantial rate hike expectations, which has caused the curve to flatten sharply in recent weeks; we believe the 2s10s curve may turn steep in the coming weeks.”

Moreover, Bloomberg economists have recently upgraded their forecasts for U.S. economic growth in the third quarter, and strong demand data makes a scenario of significant economic weakness hard to imagine.

On the other hand, Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle, indicated he is positioning for an inversion of the 2-year and 10-year, as well as the 5-year and 30-year curves within the next six months. “The best indication of tight monetary policy is the flattening of the yield curve and ultimately its inversion,” he stated.

Bank stocks under pressure, market ripple effects spreading

The flattening of the yield curve has begun to transmit to the stock market, with the banking sector being the most affected. Since banks usually borrow funds at short-term rates and lend at long-term rates, the narrowing of spread will directly compress their net interest margins, eroding profitability.

The KBW Bank Index, which tracks large bank stocks, fell into technical correction territory last week, cumulatively dropping over 10% from recent highs.

Jamie Patton, co-head of global rates at TCW Group, characterized the potential inversion as a signal of policy error. “This means the Fed has tightened too much, and will have to significantly cut rates in the future. For us, an inverted yield curve is not a sign of macroeconomic health,” he said.

This bout of curve flattening reflects a profound shift in the narrative of the U.S. economy since the outbreak of the U.S.-Iran war in February of this year—at that time, the market was still betting on a series of rate cuts to lower short-term yields, but now it has shifted to prepare for continued rate hikes.

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