The closely watched U.S. Treasury yield curve has been on a roller coaster ride in recent weeks, rattling markets at the beginning of April when, for the first time since 2019, the 2-year Treasury yield went higher than the 10-year yield. This inversion (that is, when shorter maturity Treasury yields are higher than longer dated Treasurys) was in reaction to the Federal Reserve’s vow to do whatever it takes to bring inflation down from 40-year highs.

The inversion was brief (the 10-year note was hovering near 2.8% as we went to press, about 20 basis points higher than the 2-year’s yield¹) but its appearance has left its mark. Because a yield curve inversion has been a leading indicator of a recession, it has increased talk of a possible U.S. economic downturn in the quarters ahead.

We don’t expect a recession to occur this year, but the risk of one does increase in 2023. To understand why, it’s important to look at the history of yield curve inversions and whether recent concerns about an imminent recession have merit or are overdone. 

Predictive powers

During a tightening cycle it’s normal for yields on short-term Treasury notes to rise more than long-term rates, which flattens the yield curve. And markets anticipate that relationship as we saw in the first months of this year, when the 2-year yield rose faster than the 10-year in anticipation of rate liftoff by the Fed.

But since the Fed’s 25-basis point hike in March, its governors have been signaling the central bank is prepared to fight inflation even more aggressively than first thought. As the bond market repriced the Fed’s pivot to a faster tightening cycle, the 2-year note yield overtook the 10-year yield by 7 basis points on April 1.

Five of the last six recessions, defined as two consecutive quarters of negative GDP growth, have been preceded by an inversion in this part of the Treasury yield curve. The only time the economy did not enter a recession after an inversion between 2- and 10-year yields was in 1994.

After seeing the yield curve invert, along with March’s Consumer Price Index hitting an 8.5% year-over-year growth rate, it’s not surprising that investors are concerned that the Fed may not be able to tame inflation without causing a recession. Even so, could this recent inversion be different? 

There are a few points to consider. First, the inversion was short-lived, with the 10-year yield trading some 20 basis points higher than the 2-year yield as we went to press, causing a re-steepening of the yield curve. The 2-year note, most sensitive to imminent Fed rate hikes, has been steadily rising on the back of persistent hawkish rhetoric from Fed officials. The move higher in the 10-year yield, meanwhile, reflects higher consumer and wholesale inflation numbers for March, as well as the Fed’s intention to start reducing the amount of bonds on its balance sheet as it also increases rates.

Second, another closely monitored part of the yield curve and one preferred by the Fed is the spread between the 3-month Treasury bill and 10-year note. Currently, this part of the curve remains steep at about 200 basis points and is not signaling a recession.

Third, the 2s/10s inversion could have been a false signal. Quantitative easing (the Fed’s purchase of Treasury bonds and mortgage-backed securities) has made inversions more likely by keeping longer maturity Treasury yields artificially low. Perhaps history is not a perfect comparison, given the amount of fixed income the Fed has bought and kept on its balance sheet over the past 15 years to keep markets liquid during crises. 

It is also important to recognize that while recessions typically follow an inversion of the yield curve, it doesn’t mean that a recession is imminent. In fact, as the chart below illustrates, it has historically taken 16 months on average for a recession to begin, with the six months prior to the pandemic-induced recession an outlier.

Exhibit 1: Yield Curve Inversions and Recessions