The U.S. Treasury yield curve is flattening rapidly. According to Bloomberg data, the spread between 2-year and 10-year Treasury yields, known as the 2s10s spread, narrowed at one point last week to 17 basis points, the tightest since early 2025. The 2-year and 10-year Treasury yields are currently around 4.9% and 5.2%, respectively. The 10-year yield remains near its highest level since 2007, but as the market bets on further Federal Reserve rate hikes, short-end yields are rising faster, pushing the 2s10s spread toward inversion. The market is now pricing in at least three 25-basis-point rate hikes over the next year.
Short-end yields continuing to catch up with long-end yields is changing the bond market's interpretation of this tightening cycle. Previously, higher long-end yields were mainly tied to U.S. economic resilience, inflation pressures, and fiscal risks. After the Fed delivered its first rate hike in three years in September, the market began focusing more on another question: whether the policy rate is becoming high enough to weigh on future growth. Zach Griffiths, head of investment grade and macro strategy at CreditSights, said that if the 2-year versus 10-year curve inverts further or flattens markedly, it would weaken the market's view that the U.S. economy is very strong.
Under normal circumstances, the yield curve slopes upward. Investors holding longer-dated bonds typically demand higher yields. If short-term Treasury yields exceed long-term Treasury yields, it means the market is starting to expect weaker future economic growth and rates. The yield curve has therefore long been regarded as an important indicator for observing the economic cycle. Bloomberg statistics show that since the 1960s, yield curve inversions have appeared before the past eight U.S. recessions. Since 1978, the 2-year versus 10-year curve has inverted on average about 15 months before a recession began, with the historical range running from six months to two years.
But inversion is not a mechanical predictor of recession. In 2022, several U.S. yield curves inverted, and most economists expected a recession within a year, but the U.S. economy ultimately did not enter one. Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, also believes the market has already priced in a considerable amount of rate hike expectations. The room for short-end yields to continue significantly outperforming the long end may be limited, and the yield curve could steepen again in the future.
The impact of the flattening curve has already begun to spread to bank stocks. Banks typically fund themselves at shorter maturities and then provide longer-dated loans to businesses and households, so a narrowing spread between long-term and short-term rates compresses traditional net interest margins. The KBW Bank Index entered technical correction territory last week, down 10% from its recent high. The bond market's repricing of the policy path has already started to show up in the stock market.
Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle, said he is preparing for inversions in the 2-year versus 10-year and 5-year versus 30-year yield curves over the next six months. Jamie Patton, co-head of global rates at TCW Group, believes that if the yield curve truly inverts, the signal to the market would be that the Fed may have raised rates too much and will need to cut them more substantially in the future.
Still, the 2s10s spread has not yet inverted, and third-quarter U.S. economic growth expectations have just been revised higher by economists. The 17-basis-point spread more directly reflects the market beginning to price back in the risk of overly tight policy, rather than recession being a foregone conclusion.
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