A crucial economic signal that the Federal Reserve closely watches is once again flashing a warning, raising concerns about a potential economic slowdown. The yield curve, a key measure in the bond market, has inverted again—meaning that short-term interest rates are higher than long-term rates. This phenomenon has historically been one of the most reliable indicators of an upcoming recession, with a track record spanning decades.
On Wednesday, the yield on the 10-year U.S. Treasury bond dropped below that of the 3-month Treasury note, signaling a significant inversion. The New York Federal Reserve tracks this relationship closely and provides monthly updates on recession probabilities. At the end of January, when the yield gap was 0.31 percentage points, the probability of a recession within the next 12 months was estimated at 23%. However, with the inversion now more pronounced in February, economists expect this probability to increase.
Why Is This Important?
The yield curve inverting is often seen as a sign that investors are losing confidence in long-term economic growth. When short-term interest rates rise above long-term rates, it suggests that the market expects the Federal Reserve to cut rates in the future, likely in response to a slowing economy.
Although markets usually focus on the 10-year and 2-year bond spread, the Fed prefers to compare the 10-year bond with the 3-month Treasury note. This is because short-term bonds are more sensitive to changes in Federal Reserve policy. While the 10-year and 2-year spread has remained positive, the 10-year and 3-month inversion has deepened, reinforcing concerns about economic weakness.
Trump’s Policies and Market Reactions
Since President Donald Trump took office in January, the bond market has experienced volatility. Initially, the 10-year Treasury yield surged following the November 2024 election, driven by investor expectations of stronger economic growth. However, since Trump’s inauguration, the yield has fallen by 32 basis points. This decline reflects growing fears that his aggressive trade policies, including new tariffs, could lead to higher inflation and slower economic growth.
Economists and investors are also concerned about the growing U.S. deficit and national debt. The government’s spending policies and tax cuts could put additional pressure on bond markets, further influencing investor sentiment.
Recession Fears vs. Market Stability
Despite the warning signals from the yield curve, other economic indicators remain strong. The job market continues to show resilience, and consumer spending has not yet seen a dramatic slowdown. However, surveys indicate that consumers and businesses are growing more cautious about the future.
For example, the University of Michigan’s consumer sentiment survey recently reported the highest long-term inflation expectations since 1995. Additionally, the Conference Board’s expectations index fell to levels typically associated with an economic recession.
Tom Porcelli, Chief U.S. Economist at PGIM Fixed Income, believes that while the economy is showing signs of weakness, a full-scale recession is not imminent. He suggests that the market is reacting to short-term uncertainties, particularly regarding tariffs and inflation, rather than signaling a deep economic downturn.
Market expectations now suggest that the Federal Reserve may cut interest rates by at least 0.5% in 2025 to counteract slowing growth. While some analysts believe a recession is inevitable, others argue that unless job losses increase significantly, the economy may avoid a full-blown downturn.
For now, investors will closely watch upcoming economic data, including job reports, inflation figures, and Fed policy decisions, to determine whether this warning sign translates into an actual recession or simply a temporary slowdown.
