Treasury Yield Curve Inversion Raises Concerns of Economic Slowdown

The U.S. Treasury yield curve has been reflecting increasing concerns that the Federal Reserve will wait too long before resuming interest rate cuts as economic growth slows. This development is likely to draw even more focus to February’s jobs data, due on Friday, for signals on whether the economy is cooling faster than the U.S. central bank has anticipated.

Inversions and Economic Contractions

The spread between yields of two-year and five-year notes is trading at around 3 basis points after very briefly turning negative last week for the first time since mid-December. This part of the curve is worth watching because durable inversions have preceded major economic contractions and stock market declines for the past 35 to 40 years, said Tom Fitzpatrick, head of global market insights at R.J. O’Brien. "You’ve got to pay attention to this curve again because it never got it wrong." These inversions occurred in 1989, 2000, and 2006, in each case preceding a recession.

Another worrying sign is that benchmark 10-year yields last week fell back below the fed funds rate. The 10-year yields reached 4.12% on Tuesday, while the fed funds rate held steady at 4.33%. "That is indicative of the economy essentially saying that the Fed is missing out here. It’s behind the curve," said Lou Brien, strategist at DRW Trading.

While the curve can invert for different reasons, it often reflects a concern over Fed policy when longer-dated debt yields decline faster than shorter-dated ones. This is because longer-dated yields react to growth fears, while shorter-dated debt yields will reflect Fed interest rate expectations, and the possibility that the U.S. central bank will hold rates too high for too long.

The Spread Between Yields

The closely watched spread between yields on three-month bills and 10-year notes also reinverted last week for the first time since mid-December. An inversion in this part of the curve is seen as an indicator that a recession is likely in the next 12-to-18 months. The gap between two-year and 10-year yields, also a closely watched recession indicator, has flattened back to 25 basis points, from a peak of 48 basis points in January, but has not reinverted.

Growth Fears Weigh on Long-End Yields

Longer-dated debt yields have been dragged lower by increasing concerns about U.S. economic growth, in part due to government job layoffs by Elon Musk’s Department of Government Efficiency. Uncertainty over the impact of trade tariffs and other government policies is also weighing on consumer sentiment and dampening risk appetite.

"Markets went from over-exuberance about the economy, that things are doing so well, to activity might fall off a cliff again," said Jan Nevruzi, U.S. rates strategist at TD Securities. For two-year yields, "it’s a little bit more pinned because of the limited reaction function by the Fed." Optimism on Treasury supply has supported the decline in longer-dated debt yields, with the U.S. Treasury maintaining supply levels.

Impact of Tariffs and Government Policies

The new tariffs on Mexico and Canada took effect last week, while levies on Chinese goods increased. This development led to a boost in bets that the Fed may cut rates sooner, causing two-year yields to catch up on Tuesday. The market now prices in a roughly 50/50 chance of a rate cut now in May, with a move not fully priced in until June.

"The market wants to price in some greater likelihood of some Fed activity to a greater degree this year," said Michael Lorizio, head of U.S. rates trading at Manulife Investment Management. To cut rates, however, the Fed will wait to see weakness in several economic metrics, he said.

Jobs Data and Economic Metrics

Clues about whether the United States is facing a more sustained downturn are likely to be in the jobs market, where hiring has slowed though layoffs remain relatively subdued. That could change quickly, said Brien. "When it actually turns, it’s going to turn sharply because the layoffs will come."

Friday’s jobs report for February is expected to show employers added 160,000 jobs during the month, while the unemployment rate stayed steady at 4.0%, according to economists polled by Reuters. Inflation will also remain a key focus that could keep the Fed on hold for longer if it reaccelerates.

The Risk of Delayed Rate Cuts

The risk with the Fed is that it will wait too long to cut rates because it is "fighting yesterday’s battle," said Fitzpatrick. This concern is reflected in the Treasury yield curve inversion, which has reached a "code orange" level of caution. If it inverts decisively with drops in longer-dated yields leading the move, it may constitute a "code red."

For benchmark 10-year yields, Brien says further drops would be a stronger sign that the Fed may need to reconsider its policy. "If the 10s fall to 4% and the fed funds are still up at 4.5%, then it starts to look very suspect about the Fed having missed the turn and falling behind the curve."

Conclusion

The Treasury yield curve inversion raises concerns that the Federal Reserve will wait too long before resuming interest rate cuts as economic growth slows. The jobs market, inflation data, and economic metrics will be closely watched for signs of a sustained downturn. If the Fed waits too long to cut rates, it may miss the turn and fall behind the curve, leading to further economic contractions and stock market declines.