The US Treasury yield curve is moving closer to inversion, adding to signs from the bond market that continued Federal Reserve tightening could weigh on the economy.
Last week, the spread between 10-year and 2-year Treasury yields narrowed to as little as 17 basis points, the smallest gap since early 2025. The flattening picked up after the Fed completed its first rate hike in three years this month and indicated that more tightening is likely. Markets are currently pricing in at least three additional 25-basis-point hikes over the next year.
The 2s10s spread has compressed sharply
The 10-year Treasury yield is now around 5.2%, while the 2-year yield is about 4.9%, leaving the spread fluctuating within roughly 30 basis points, one of the narrowest levels seen in recent years. The 10-year yield is also near its highest level since 2007.
After the Fed’s rate move this month, short-dated yields climbed faster than long-dated yields, pushing the curve flatter. That shift has been painful for bond investors who entered the year betting on a steeper curve.
Zach Griffiths, head of investment-grade and macro strategy at CreditSights, said that an inversion or a sharp flattening in the 2-year/10-year curve would make markets question the view that the economy remains very strong, and that this is what bond market pricing is now starting to reflect.
Recession warning signal still carries weight, but not without doubt
An inverted yield curve has long been treated as a collective market view that the Fed may have tightened too far and that economic momentum is weakening. According to Bloomberg data cited in the report, since 1978 the 2-year/10-year curve has inverted on average about 15 months before a recession starts, with the lead time ranging from 6 months to 2 years.
Even so, confidence in that indicator has been damaged in recent years. In 2022, several US yield curves inverted and many economists expected a recession within 12 months, but that downturn never arrived. The US economy instead showed resilience through the Fed’s aggressive 2022-2023 tightening cycle, a regional banking crisis, a global trade war, and this year’s spike in energy prices.
Policymakers are paying closer attention to the spread between 3-month and 10-year Treasuries. That measure remains relatively steep and has not yet issued a clear warning.
Markets are split on whether inversion is imminent
There is no consensus on whether the curve will move deeper toward inversion.
Gennadiy Goldberg, head of US rates strategy at TD Securities, said the market has already priced in a large amount of rate-hike expectations, leaving limited room for short-end yields to rise further. In his view, the 2-year/10-year spread could steepen in the coming weeks. He said the market has fully priced in aggressive hike expectations, which drove the sharp flattening seen in recent weeks, and that the 2s10s curve may turn steeper over the next several weeks.
Bloomberg economists have also raised their forecast for US economic growth in the third quarter, while strong demand data has made a material slowdown harder to picture.
On the other side of the trade, Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle, said he is positioning for inversion within the next six months in both the 2-year/10-year curve and the 5-year/30-year curve. He said the best sign of monetary tightening is the flattening of the yield curve and, eventually, inversion.
Bank stocks are already under pressure
The flatter curve is beginning to affect equities, with banks taking the first hit. Banks typically borrow at short-term rates and lend at long-term rates, so a narrower spread directly squeezes net interest margins and hurts profitability.
The KBW Bank Index, which tracks large bank stocks, fell into technical correction territory last week and is down more than 10% from its recent peak.
Jamie Patton, co-head of global rates at TCW Group, described a potential inversion as a signal of policy error. He said it would mean the Fed had tightened too much and would eventually have to cut rates sharply. In his view, an inverted yield curve is not a sign of macroeconomic health.
The latest flattening also reflects a broader shift in the market’s narrative on the US economy since the outbreak of the US-Iran war in February this year. At that point, investors were still betting that a series of rate cuts would pull down short-term yields. Now the market has turned toward preparing for continued rate increases.