The yield curve is speeding toward inversion — here’s what

The bond market’s most reliable gauge of the U.S. economic outlook for the past half-century is hurtling toward inversion at a faster pace than it has in recent decades, raising fresh worries about the economy’s prospects as the Federal Reserve begins to consider aggressively hiking interest rates.

The widely followed spread between 2-year
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and 10-year Treasury yields
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shrank to as little as 13 basis points on Tuesday, a day after Fed Chairman Jerome Powell opened the door to raising benchmark interest rates at more than a quarter percentage point at a time. Though slightly higher on the day as of Tuesday afternoon, the spread is down from as high as 130 basis points last October.

Investors pay close attention to the Treasury yield curve, or slope of market-based yields across maturities, because of its predictive strength. An inversion of the 2s/10s has signaled every recession for the past half-century. That’s true of the early 1980’s recession that followed former Fed Chairman Paul Volcker’s inflation-fighting effort, the early 2000’s downturn marked by the bursting of the dotcom bubble, the 9/11 terrorist attacks, and various corporate-accounting scandals, as well as the 2007-2009 Great Recession triggered by a global financial crisis, and the brief 2020 contraction fueled by the pandemic.

Inversions have already struck elsewhere along the U.S. Treasury curve, suggesting the dynamic is broadening out and could hit the 2s/10s soon. Spreads between the 3-, 5-, and 7-year Treasury yields versus the 10-year, along with the gap between 20-and 30-year yields, are all now below zero.

“The yield curve has the best track record within financial markets of predicting recessions,” said Ben Emons, managing director of global macro strategy
at Medley Global Advisors in New York. “But the psychology behind it is just as important: People begin to factor into their minds interest rates that are perhaps too restrictive for the economy and which could lead to a downturn.”

The following chart, compiled in February, shows how the 2s/10s inverted ahead of past recessions and has continued to flatten this year. The 2s/10s most recently inverted for a brief time in August and September of 2019, just months before a downturn sparked by COVID-19 hit in February to April of the following year.

Ordinarily, the curve slopes upward when investors are optimistic…