The bond market has been flashing a recession warning for months. It might be worsening.
The yield on the 10-year Treasury sits roughly 0.80 percentage point below the three-month bill yield.
Futures contracts show it is expected to continue slipping, to more than 1.50 percentage points lower, by May, according to Credit Suisse analysts.
Traders are betting that section of the yield curve will remain inverted through November 2025.
Wall Street has long used the Treasury yield curve—the spread between yields on long-term bonds and short-term notes—as a barometer for economic health. Long-end yields are typically higher because investors demand more income for future uncertainty.
When short-end yields rise above longer ones, that has historically represented expectations for the Federal Reserve to raise the benchmark rate enough to drag the economy into a recession.
What problems does an inverted yield curve pose?
Domestic banks and foreign investors alike may struggle when the yield curve is off-kilter.
Banks earn income by borrowing cash and lending it out at a higher rate. When funding rates are loftier than what they can make on long-term loans, that constricts margins.
Foreign investors into the U.S. bond market similarly use short-end rates to hedge their currency exposure, because they borrow dollars to buy long-dated Treasurys and want to reduce risk tied to foreign-exchange fluctuations. When U.S. yields invert, the trade becomes unprofitable and removes demand for U.S. debt, potentially raising domestic borrowing costs.
For years, Japanese investors had scooped up U.S. bonds in particular not just because they offered higher yields than Japanese bonds but because yields on longer-term Treasurys were higher than those on shorter-term Treasurys. This allowed them to earn good returns by borrowing dollars at short-term rates and then buying longer-term bonds—a move that also acted as a hedge against currency fluctuations.
Now, the trade doesn’t work, because short-term U.S. rates have caught up with longer-term yields.
Despite Japanese government bonds' low yields, which range up to about 1.85% on a 40-year bond, they attract investors in Japan even now because they can be purchased without the risk of unfavorable currency moves or change in hedging costs, analysts point out.
Mitigating the impact on the market, firms can shrink their holdings of U.S. bonds by not buying new bonds when old ones mature, rather than just dumping Treasurys.
Selling bonds that have fallen in price is a more difficult decision because it means booking losses, analysts say. But it makes more sense the more that the Fed raises rates, increasing the cost of rolling over short-term borrowing contracts. And it becomes even more likely if yields rise on Japanese bonds.