Historically, an inverted yield curve—where the yield on longer-term Treasury bonds is lower than that of shorter-term Treasury bonds—has foreshadowed a recession in the next year or two. The inversion implies that investors’ outlook for the economy over longer periods has deteriorated compared with their near-term views.
But there are several other reasons why part of the yield curve has flattened. The Fed has embarked on quantitative easing (QE) during the last two interest rate cycles. The first came in response to the global financial crisis and the second to the COVID-19 pandemic. As shorter-term Treasury rates approached zero, the Fed could stimulate the economy only by lowering yields on the long end of the curve, thus creating a flatter curve.
In the post-COVID cycle, accelerated QE plus strong demand for Treasuries from overseas markets and pension funds have helped drive down longer-term yields.
Now the uncertainty over how much the Fed will continue to tighten monetary policy is flattening the curve, this time by short-term rates rising more than longer-term rates. “The Federal Reserve has already signaled its plans to raise rates above the neutral rate to about 2.75%,” Madziyire said. “The risk is that with inflation already running at a 40-year high, the Fed may have to raise rates higher than anticipated.”
The result has been a rapid narrowing of spreads between 2-year and 10-year Treasury bonds, to just 6 basis points on March 29.1
“With the Fed just starting to raise the federal funds rate, a 6-basis-point spread is significantly narrower than normal at this early stage of the cycle,” Madziyire said. “Many investors may think a recession is a foregone conclusion.”