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The bond market is nearing a point where it signals that a series of interest rate hikes by the Federal Reserve will begin to shift the narrative toward the risk of a U.S. economic slowdown.

The additional yield investors demanded to hold 10-year Treasury bonds compared to two-year bonds narrowed to just 17 basis points last week, marking the tightest spread since early 2025, according to Bloomberg Middle East.

This phenomenon, known as the flattening of the yield curve, increases the likelihood that the yield on 10-year bonds will soon fall below those of shorter maturities—a closely watched phenomenon known as an inverted yield curve.

Historically, an inverted yield curve has been a strong indicator, preceding each of the last eight recessions dating back to the 1960s, although its predictive accuracy proved less reliable earlier this decade.

At its core, it reflects bond investors’ view that the Federal Reserve will raise interest rates high enough to hinder the economy in its effort to curb inflation. Such an outcome would have wide-ranging implications across financial markets, particularly for stocks trading near record highs.

This is a scenario that more investors are preparing for after the central bank raised interest rates this month for the first time in three years and signaled that further hikes are likely. It also highlights how the Fed’s tight monetary policy is reshaping the risk balance following a wave of bond selling that reflected rising price pressures amid strong growth.

Zack Griffith, Head of Investment Grade Strategy and Macro Economics at research firm CreditSights, said, “Seeing the two-year and 10-year curves invert or flatten sharply casts doubt on the idea that the economy is too strong, and this is part of what is being priced into the bond market.”

An inversion would reverse the global trend of yield curve normalization seen since 2024. Bond investors tend to demand higher yields for greater uncertainty associated with locking up their funds for longer periods, meaning yield curves typically slope upward.

Until last month, this was indeed the trajectory, with long-term yields rising partly due to concerns that the Federal Reserve’s credibility in fighting inflation was eroding under Chair Kevin Warsh.

However, after the central bank raised rates in September, shorter maturities led the rise in yields. Traders are pricing in at least three quarter-point increases in Fed interest rates over the next year.

Some do not expect an inversion soon, arguing that the extent of rate hikes already priced in makes it difficult for short-term rates to rise further relative to long-term yields.

Gennadi Goldberg, Head of U.S. Interest Rate Strategy at TD Securities, said, “The market has already factored in significant Fed rate hikes, which has driven the curve to flatten sharply in recent weeks. This leads us to believe that the two-year and 10-year curve is likely to move toward further steepening in the coming weeks.”

It is also difficult to envision a severe economic downturn at this point. Economists have just raised their forecasts for U.S. growth in the third quarter, driven by strong demand, according to the latest Bloomberg monthly survey.

However, others believe that the flattening trend has room to continue. Ed Husain, a portfolio manager at Columbia Threadneedle, said he is positioning for an inversion of the two-year to 10-year yield curve and the five-year to 30-year yield curve over the next six months, as the Federal Reserve tightens its policies to cool the economy and inflation. He said, “The best indicator that monetary policy is becoming more restrictive is the flattening of the yield curve, and ultimately its inversion.”

The two-year and 10-year bonds entered this week with yields of approximately 4.9% and 5.2%, respectively. The yield on the 10-year bond, a key global benchmark for bonds, is near its highest level since 2007.

When the curve is inverted, it often reflects concerns about growth prospects, as interest rate hikes are designed to address inflation by dampening demand for loans. A slowdown in growth could eventually pave the way for the Federal Reserve to cut interest rates, pushing long-term yields lower relative to shorter-term yields.

Since 1978, the two-year to 10-year yield curve has inverted, on average, about 15 months before the start of a recession, with the time lag ranging from six months to two years, according to Bloomberg data.

However, the curve’s predictive power has faced increasing scrutiny in recent years. Various U.S. yield curves inverted in 2022, with most economists forecasting a recession within 12 months. This never materialized, as the economy proved largely resilient to the Federal Reserve’s tightening campaign in 2022 and 2023, a regional banking crisis, a global trade war, and the sharp rise in energy prices this year.