Major US recession indicator flashes strongest warning in 40 years

The U.S. Treasury yield curve has inverted to extremes not seen since the early 1980s with likely more to come as the Federal Reserve continues its most aggressive monetary policy shift in decades.

On Nov. 28, 2-year Treasury yields climbed 77 basis points higher than 10-year yields, the highest such difference since 1981. A year ago, the 10-year yield was 100 basis points above the 2-year yield.

Inversion — in which shorter duration bond yields exceed longer duration yields — has become a strong indicator of a looming recession.

"We think that yield curve inversions actually predict that the Fed's monetary policy is getting too tight, which could trigger a financial crisis that could quickly morph into a credit crunch, causing a recession," Ed Yardeni, president of Yardeni Research, wrote in a Nov. 27 note.

Across the curve

Several portions of the curve are deeply inverted. Yields on 3-month Treasurys landed 72 bps higher than 10-year yields on Nov. 28. A higher 3-month yield compared to 10-year yields is considered one of the most accurate recession predictors. Meanwhile, 1-year yields were 102 bps higher than 30-year yields.

The curve has inverted as the Fed has hiked its benchmark interest rate 375 bps since March, with market watchers expecting another 50-bps increase at its December meeting.

Slowing economic growth and a hawkish Fed caused the curve to invert, conditions unlikely to change in the near term, said Antoine Bouvet, a senior rates strategist with ING.

"We think the U.S. Treasury yield curve is already at extreme levels and will dis-invert next year as the Fed's hiking cycle comes to an end," Bouvet said in an interview.

The Fed is likely to hike rates by 25 bps in both February and March, bringing the upper end of the target range for the federal funds rate to 5% where it will stay into 2024, economists with S&P Global Market Intelligence wrote in a Nov. 21 note.

"Barring a much faster decline of inflation, we think it highly unlikely that the Fed would 'pivot' and start cutting rates in the second half of 2023 as priced into futures and interest-rate swaps and as suggested by the latest downturn in Treasury yields," the economists wrote