Yield curve inversion between 2-year/10-year bonds signals a recession risk

The yield curve between the 10-year U.S. Treasury and the 2-year U.S. Treasury has reached its largest inversion since the early 1980s on Tuesday morning, a sign that an economic recession is on the horizon.

The difference between 2-year and 10-year yields is called the “yield curve” and is a recession signal when investors are getting better repayment for snapping up shorter-term bonds than longer-term ones.

The 10-year Treasury yield trades to near 3.73% this morning while at the same time, the 2-year yield trades around 4.50%, with the spread between the two bonds hitting a fresh low of -0,77%, the widest negative gap since the early 1980’s when the U.S. suffered significant recession and the highest unemployment rate (almost 11%) since post-WWII.

10-2-year Treasury Yield Spread, Daily chart

The yield inversion is closely watched by analysts and investors since the yields on long-term U.S. Treasuries have continued to drop below short-term Treasuries throughout 2022.

Where historically a yield curve inversion has often been the warning of an impending recession, this time it could potentially mean that investors are anticipating that the short-term rates will be higher in the near-term as the Fed wants to curb record-high inflation, and much lower long-term due to Fed intervention that will reduce rates in late 2023 after inflation would come back down.

The above anticipation and the widening of the yield curve are based on the lower-than-expected Consumer Price Index in October, meaning that inflation has peaked in the United States and has started coming down.