US Treasury Key Yield Curve Inversion Becomes Longest On Record

The key bond market signal of an upcoming recession has been flashing red for the longest time ever, stated Deutshe Bank. This signal is part of the Treasury yield curve that plots two-year and 10-year yields, which has been inverted since early July 2022. This means that short-term bonds yield more than longer ones. The current 2/10 curve inversion has exceeded a record 624-day inversion in 1978. 

When short-term bonds yield more than longer maturities, it is considered a time-honoured signal of an upcoming recession. The reason for this is that investors expect interest rates to remain high in the short term as the Federal Reserve battles inflation. Meanwhile, long yields are lower because investors expect the central bank to cut interest rates to stimulate a weakening economy.

An inverted yield curve is typically bad for economic activity and financial markets, as higher short-term yields increase borrowing costs on consumer and commercial loans, while lower compensation for long-term lending discourages risk-taking. 

Despite this, the current deeply inverted yield curve has not yet caused a recession, and the U.S. economy continues to perform better than expected. The Fed has kept its outlook unchanged for three interest rate cuts this year, as it expects inflation to decline despite strong economic activity. 

This is partly due to high consumer savings following the Covid-19 pandemic, which has provided a buffer against rising borrowing costs. Additionally, the Fed has managed to contain banking turmoil resulting from changes in the yield curve by offering emergency liquidity measures. However, an inverted yield curve should ultimately be a significant headwind for the economy, as capitalism works best when there is a positive return for taking more risk with lending and investments further out the curve.