Yield curve inversion

The yield curve inversion tracks the spread between two Treasury maturities, most commonly the 10-year yield minus the 2-year yield, or the 10-year minus the 3-month bill. Under normal conditions investors demand a higher yield to lend money for longer, since more time means more risk of inflation or default eating into the return, so the curve slopes upward. An inversion is simply that spread turning negative: the shorter maturity trades at a higher yield than the longer one.

Watch the sign and the depth of the spread, not just whether it crossed zero once. A 10s-2s spread that dips to minus 5 basis points and bounces back within a week reads very differently from one that sits at minus 50 basis points for six months. Markets and economists also track which segment inverted first, since the 3-month/10-year spread and the 2-year/10-year spread don't always flip at the same time and have historically carried slightly different lead times to a downturn.

An inversion has preceded every US recession going back several decades, but the lead time between the inversion and the actual downturn has ranged from about six months to close to two years, which makes it useless as a timing tool even when it's a reasonably reliable warning sign. There have also been inversions, including a prolonged one through 2022 and 2023, that were followed by a soft landing rather than a recession, at least within the window traders were watching. The curve reflects what bond investors expect about future growth and Fed policy, not a mechanical trigger for a slowdown, and a steep uninversion, the curve snapping back to positive, has its own history of showing up right as a recession actually begins rather than as an all-clear signal.

Take a session where the 2-year Treasury yields 3.85% and the 10-year yields 4.55%. That's a positive, upward-sloping curve, a 70 basis point premium for lending longer. Now compare a different stretch where the 2-year yields 4.60% and the 10-year yields 4.35%, a 25 basis point inversion. Short-term rates sitting above long-term ones there reflects a market pricing in Fed rate cuts ahead, since a bond bought today at the higher short yield won't get to reinvest at that same rate once it matures, while the 10-year yield already bakes in an expectation of where policy is headed over the next decade.