Key takeaways
Two-year Treasury yields recently fell below 10-year Treasury yields signaling an end to an extended period of a so-called inverted yield curve.
Markets are poised for Federal Reserve interest rate cuts beginning in September.
While an inverted yield curve is viewed by some market observers as a harbinger of recession, since 2022 – when the yield curve for Treasuries inverted – the economy has exhibited a stubborn resilience.
Anticipation of Federal Reserve (Fed) interest rate cuts is resonating across the U.S. bond market. One notable change is that the shape of the Treasury yield curve, which has been in an inverted state since 2022. This unusual occurrence represents an environment where yields on shorter-term Treasuries are higher than those for longer-term Treasuries. The inverted yield curve contrasts with typical market behavior, where investors are rewarded with higher yields for the willingness to purchase longer-term debt.
Yet between early 2022 and mid-2023, the Fed raised the federal funds rate, the overnight rate banks charge each other for short-term loans, from near 0% to a top level of 5.5%. It resulted in across-the-board yield increases. However, short-term rates (i.e., 3-month Treasury bills) are closely linked to the fed funds rate. The Fed’s rapid rate hikes led to short-term Treasury yields rising faster than long-term yields, inverting the yield curve by July 2022.
Now, expectations are that the Fed will cut rates in September, its first rate cut since 2020. Bond investors are already pricing in initial Fed rate cuts, resulting in declining yields across the board. Two-year Treasury yields exhibited the largest declines, to the point that the yield curve is no longer inverted between 2-year and 10-year Treasuries. From earlier 2024 peaks, the 2-year Treasury yield fell 1.30%, compared to a 1% drop in the 10-year Treasury yield.1
“The fed funds target rate has its most direct impact on the short end of the yield curve,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Longer term rates move more independently, so they may fluctuate up-and-down, but we’re seeing less movement in short-term rates.” Nevertheless, markets are reflecting, in advance, the potential for upcoming Fed rate cuts.
Understanding an inverted yield curve
A simple way to view the yield curve is by comparing current interest rates, or yields, on U.S. Treasury securities with maturities of three months, two years, five years, 10 years and 30 years. Investors typically demand higher yields when investing their money for longer periods of time. This is referred to as a normal, upward sloping yield curve. In this scenario, yields rise along the curve as bond maturities lengthen. The chart below depicts a normal, upward sloping yield curve among these U.S. Treasury securities of varying maturities, depicting actual yields in the Treasury market at the end of 2021. At that time, the yield on 3-month Treasury bills stood at 0.05% and moved progressively higher as maturities extended along the yield curve, up to a yield of 1.90% on 30-year Treasury bonds.1
However, at rare times, the yield curve inverts. The use of this term does not necessarily indicate that the slope moves consistently higher to lower across the yield spectrum when reading the chart from left to right. But it can mean that yields on some shorter-term securities are higher than those for some longer-term securities.
In July 2022, 2-year Treasury yields first exceeded those of 10-year Treasuries. Then in late October 2022, the yield on the very short-term 3-month Treasury bill moved above that of the 10-year Treasury note. While the 2-year/10-year inversion may be over, the 3-month/10-year yield inversion continues.1
Another way to monitor the yield curve’s trend is the spread between 3-month Treasuries and 10-year Treasuries. In 2024, the negative interest rate spread narrowed (see chart below). However, in recent months, yields on 10-year Treasuries dropped faster than those of 3-month Treasuries. As a result, the negative yield spread (favoring 3-month T-Bills) held relatively steady despite the changing interest rate environment.
Haworth says the rate spread is dependent on Fed actions. “The inverted yield curve is most likely with us until those Fed rate cuts take hold.”
The inversion between the two-year and 10-year Treasury, often considered a signal of a pending recession, was the longest period of an inverted curve in history.2 Yet no recession has occurred in that time. “Market wisdom is that when the yield curve reverts to normal, a recession begins. But to the extent that occurred in the past, if was only coincidence,” says Haworth. Notably, the U.S. economy grew at annualized rates of 1.4% in 2024’s first quarter and 3.0% in the second quarter. Haworth believes there are no immediate recession fears on the horizon. “As the Fed begins to lower rates, it eventually reduces economic pressure.” But he notes that longer-term rates, such as 10-year Treasury yields which are more closely linked to mortgage rates, may remain somewhat elevated. That may offer little relief for the sluggish housing market.
How the yield curve could change
The next question is when to expect a return to a normal, upward sloping yield curve, when long-term bond yields exceed those of shorter-term bonds. Haworth sees two different scenarios, one preferred over the other.
“If long-term bond yields begin to fall, it likely reflects declining inflation. As that occurs, the Fed will feel more comfortable cutting short-term rates.” Haworth believes that the preferred way to see the yield curve return to normal is with short-term rates declining more precipitously than long-term rates. Declining short-term Treasury yields would likely follow fed funds rate cuts.
Haworth says the “Goldilocks” version of this scenario is one where declining inflation is paired with a growing economy. “In this circ*mstance, the Fed will feel more confident about its ability to lower rates without risking a significant inflation uptick.”
A less desirable scenario, according to Haworth, is one where the economy appears at risk. “The Fed will cut short-term rates to offset a recession threat,” says Haworth. “That could happen, for example, if unemployment suddenly moves sharply higher, which could curtail consumer spending and trigger a recession.”
“At this point, Fed rate cuts aren’t meant to stimulate economic growth,” says Haworth. “The Fed’s goal is likely to get interest rates back to what they consider to be a neutral level so the economy can remain at a normal growth rate.”
Investment considerations in today’s unusual environment
With yields higher on short-term securities, it’s no surprise investors have put significant sums to work on the short-end of the yield continuum. However, Haworth recommends investors also consider longer-term bonds, with yields that are far more attractive today than they were at the start of 2022. “The market is pricing bonds with the expectation of coming Fed rate cuts,” says Haworth. “People who don’t intend to keep money in cash over the long term should implement a plan to start migrating money out of cash and into longer-term bonds.”
One consideration for bond investors is the risk of rising interest rates. When interest rates rise, values of bonds held in an existing portfolio lose market value. “A 30-year bond is much more sensitive to interest rate movements than a 6-month bond,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. Yet Freedman believes attractive interest rates create opportunities for investors. “It may be a time for fixed income investors to spread out exposures across the maturity spectrum.”
Haworth notes there’s increasingly positive investor sentiment for non-Treasury segments of the market. With certain non-taxable portfolios, this includes non-government agency issued residential mortgage-backed securities, while managing total portfolio duration using longer-maturity U.S. Treasuries. Certain tax-aware portfolios can benefit from municipal bonds, including some longer-duration and high-yield municipal securities. Trust portfolios may benefit from reinsurance as a way of capturing differentiated cash flow with low correlation to other portfolio factors such as economic trends.
Check-in with your wealth planning professional to make sure you’re comfortable with your current mix of investments and that your portfolio’s asset allocations remain consistent with your goals, risk appetite and time horizon.
Frequently asked questions
A yield curve plots the interest rates paid by bonds of comparable credit quality across various maturities. A Treasury yield curve provides a comparison of government-issued bond yields of different maturities. A typical yield curve will trace current yields for Treasury debt securities with yields of three months, two years, five years, ten years and 30 years.
Typically, investors expect to earn higher yields from bonds with longer maturities. In a normal environment, the yield curve will be upward sloping. For instance, that means the yield on shorter-term bonds will be lower than the yield on longer-term bonds. However, in certain circ*mstances, the yield curve inverts and slopes downward. In this environment, yields on short-term securities exceed those of long-term securities. While some market observers view an inverted yield curves as harbinger of recession, that hasn’t happened in the current cycle since the yield curve first inverted back in 2022.
The yield on a U.S. Treasury security, its effective interest rate, indicates the income that will be generated for an investor when purchasing a bond. For instance, when investing $10,000 in a 10-year U.S. Treasury note with a 4% yield, the investor will be paid income of $400 per year. Bond yields are locked in when an investor purchases a specific security, but yields paid by newly-issued U.S. Treasury securities will vary on a day-to-day basis.
