The 'yield curve' could invert again, but is that still a reliable recession signal?

The Treasury yield curve is flattening, and it could go to zero, says one fixed-income strategist.

What has been a reliable harbinger of trouble for stocks and the U.S. economy has begun to emerge in the $31.5 trillion Treasury market.

The Treasury "yield curve" - the spread between shorter-term and longer-term yields - has flattened dramatically since the start of the Iran war as oil prices surged and Wall Street began bracing for the Federal Reserve to deploy interest-rate hikes to crack down on inflation.

A look at the 2-year Treasury yield BX:TMUBMUSD02Y shows it now sits only about 22 basis points (0.22 percentage points) below its 10-year BX:TMUBMUSD10Y counterpart, down from closer to 75 basis points in February.

As the two yields move closer together and an "inversion" looks more likely, in which the 2-year yield rises above the 10-year yield, people tend to start talking again of the predictive power of the yield curve, which has often preceded past recessions. It can also hurt certain sectors of the market, particularly financials.

"The yield curve could invert," said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott, on Tuesday. Once the gap narrows this much between long- and short-end yields, it rarely stays there, he said. It usually moves out to about 50 basis points, or collapses to zero.

"I'd say zero" is more likely, LeBas added.

Are recession risks rising?

The yield curve has flattened out over roughly the past seven months as traders on Wall Street pushed the policy-sensitive 2-year Treasury yield dramatically higher.

They've done so, as the below chart shows, in anticipation of the Fed kicking off its second rate-hiking cycle since 2020.

While past U.S. recessions occurred about a year after inversions, there have been "three notable false positives," according to researchers at the Cleveland Fed. Those were in late 1966, "a very flat curve in late 1998," and the late 2022 to late 2024 inversion, they said.

Yet even moving to a flatter yield-curve environment can have negative consequences. Banks stand to earn less on some bread-and-butter activities, such as making longer-term loans to customers, relative to the interest they pay out to clients on short-term deposits.

Financial stocks XX:SP500.40 in the S&P 500 index SPX were down another 1.8% on Tuesday, on pace to largely erase their gains for the year, according to FactSet. Utilities also tend to be capital intensive. That S&P 500 sector XX:SP500.55 already was down 4.8% on the year through Tuesday.

All this points to jitters around the potential scope of this rate-hiking cycle. It also speaks to weakness under the surface of the stock market, despite the S&P 500 and Nasdaq Composite COMP both sitting near record highs.

Last week, the Fed lifted its short-term rate for the first time in three years, bringing it to a range of 3.75% to 4%. The 2-year Treasury yield's perch near 4.76% on Tuesday suggests more rate hikes look likely.

Goldman Sachs chief economist Jan Hatzius on Tuesday said he expects another rate hike at the conclusion of the Fed's October meeting in five weeks.

Hatzius pointed to the Iran war escalation, higher oil prices and the subsequent refinery bottleneck as catalysts for the current hiking cycle, while noting U.S. economic growth and inflation also have been higher than expected.

LeBas at Janney expects the Fed to hike rates by 75 basis points overall, enough to take out the "insurance" rate cuts made in 2025. While hiking rates into a backdrop of higher energy prices isn't usually "a good strategy," he said, there's still plenty of positive spillover from the artificial-intelligence spending boom for the economy - and the stock market.

"You don't need to look any further than the equity market response to see how insignificant a 5% [10-year Treasury] yield is to risk assets," LeBas said. "At some point that will fade," he said of the tech-investment boom. "But it's not today."

The 10-year Treasury yield hit 5% last week, a level that's been a stumbling point for stocks in the past. It has fluctuated around that threshold since, with the trajectory largely following oil prices for months.

Goldman's commodity strategists expect Brent crude prices (BRN00) to gradually retreat back to $85 a barrel by December, from around $100 on Tuesday. That would give the Fed some breathing room.

Meanwhile, the economy "remains healthy and has shown it can accommodate the higher rates of interest and inflation," said Paul Christopher, head of global investment strategy at Wells Fargo Investment Institute.

"We like our target for the S&P 500 index this year of 7,800-8,000," Christopher said, adding that he isn't expecting a completely flat yield curve, nor an inversion.

Back at the Cleveland Fed, researchers focused on the yield-curve indicator point out that inversions preceded each of the past nine U.S. recessions, including the most recent one in March 2020.

Their indicator focuses on the gap between the 3-month Treasury-bill rate BX:TMUBMUSD03M and 10-year yield. Its most recent reading from August pointed to only a 12.3% chance of a recession within a year.

-Joy Wiltermuth