By Karen Brettell and Davide Barbuscia
(Reuters) - A closely watched part of the U.S. Treasury yield curve, a key bond market indicator of an upcoming recession, turned positive for the first time in two years, as concerns grew that the U.S. economy is heading into a downturn.
An inversion in the yield curve comparing two- and 10-year Treasury yields typically indicates that a recession is likely in the next one to two years, though this inversion has lasted longer than in previous episodes.
The curve then usually turns positive before a downturn begins, with short-term yields dropping faster than longer ones on expectations the Federal Reserve will cut interest rates to support a weakening economy.
"An inversion is the long-leading indicator of recession, and a disinversion is the signal that maybe you're entering or you're near an actual recession," said Matthew Nest, global head of active fixed income at State Street (NYSE:STT) Global Advisors.
In the past four recessions - 2020, 2007-2009, 2001 and 1990-1991 - the 2/10 curve had turned positive by the time a recession occurred, according to a Deutsche Bank analysis published last year. The interval between a disinversion and the beginning of a recession varied, ranging roughly between two and six months in those four instances.
The 2/10 curve had been continuously inverted since early July 2022, exceeding a previous inversion record from 1978. Some in the market had questioned its accuracy as a recession indicator this time around because of optimism that the U.S. could escape prolonged economic pain.
But weak economic data last week re-ignited recession fears and a prompted a sharp repricing in U.S. interest rate cut expectations, with investors now expecting the Fed to lower rates by 120 basis points this year - about double the easing that was priced in last week.
"The potential for immaculate disinflation was the rebuttal to the inversion story, but we've always been leaning toward (the idea) it may just be delayed rather than a false signal this time around," said Nest.
Two-year Treasury yields, sensitive to expected changes in monetary policy, have dropped over 50 basis points over the past week to 3.84%. Benchmark 10-year yields have decreased by about 40 basis points over the past week and were last at 3.76%.
The gap between two- and 10-year Treasury notes hit 0.4 basis points in early trade, turning positive for the first time since July 2022. Later on Monday the curve inverted again, with two-year yields above long-term ones by about 8 basis points.
The disinversion is a signal that the market is "screaming that the Fed needs to cut rates," said Matthew Miskin, John Hancock Investment Management's co-chief investment strategist.
"Whether or not that's justified ... we'll just have to see how lasting this risk-off environment is."