One of this year's most-followed recession indicators has gone from flashing red to amber.

A combination of three rate cuts by the Federal Reserve and some green shoots in global economic data has been enough to normalize the U.S. Treasury yield curve.

The three-month to 10-year Treasury yield curve inverted — a situation where shorter-dated debt yields more than longer-dated debt — on March 22, sparking widespread concern that a recession was on the way. An inverted yield curve has been a reliable indicator of recessions in the past, preceding every downturn since 1961.

The inversion of the three-month to 10-year curve peaked August 28 at negative 52 basis points, but as the Fed began cutting rates to counter slowing growth, the curve reverted Oct. 11, and by Dec. 18 both the three-month to 10-year and the two-year to 10-year spreads were just off their 12-month highs.

"Some of the recession risk has been priced out, and broadly speaking in the U.S. and China data there has been some pick up while EU data has shown tentative stabilization," said David Riley, chief investment strategist at BlueBay Asset Management.

BlueBay's implied recession risk model of the Treasury yield curve is now 22%, down from a peak of 41% at the end of August.

"There's been quite a meaningful repricing," Riley said.

How high can the yield go?

Much of the recent movement has been on the 10-year yield, which rose from 1.72% at the close of Dec. 3, to 1.92% at the end of Dec. 18. A bullish turn has seen investors drop defensive assets, including longer-dated Treasurys, in favor of riskier assets that they think will provide better returns, such as U.S. equities. As a result, the S&P 500 has been continuously breaking records in the fourth quarter of 2019, breaching 3,200 points on Dec. 20.

But how far can the yields on U.S. Treasurys go?

According to Riley, the top end for 10-year yields is probably 2.25%, unless U.S. growth accelerates.

"To break meaningfully through 2.25%, you're going to have to see [German] bund yields move higher as well. There is a gravity effect from European and Japanese fixed income. There's a limit to how far Treasurys can go in a yield-starved world."

There appears to be little prospect of that. Yields on 10-year German bunds were languishing at negative 0.23% on Dec. 20, and the ECB has unleashed a further bout of quantitative easing which will likely keep yields suppressed.

The heavily debt-laden Italian and Greek governments are paying just 1.43% and 1.39% respectively to borrow for 10 years. Japanese 10-year government bonds are yielding zero percent.

Risk abatement

Stronger industrial output and consumption data in China, and an apparent bottoming of global manufacturing data, combined with the "phase one" trade deal agreed upon with the U.S., has boosted market sentiment. But for further risk appetite to emerge, investors would need to see stronger signs, Riley said.

"If the abatement of these geopolitical risks is sustained, the early green shoots in U.S. and global manufacturing could take root," said Wen-Wen Lindroth, lead cross-asset strategist at Fidelity International.

"[If] China data starts picking up in the first half as well, if you get that and the U.S. is remaining at a cruise speed of 2-ish-percent, then you could get further steepening," he said.