An inverted yield curve driven by short rates rising more than long-term yields has preceded every US recession since 1960 and is therefore a closely watched metric among investors regarding the outlook for the economy and markets. The curve, as measured by the 2s/10s spread, has been flattening through most of the year and currently sits at just under 25 bps. With elevated inflation and a strong labor market, the Fed seems intent on delivering a series of rate increases beginning in March. Meanwhile, given the low probability of an immediate peaceful resolution overseas, long-term yields are expected to remain suppressed, likely leading to a further flattening bias in the curve in the coming months. With the potential for a yield curve inversion—indeed, the 1-yr. forward 2s/10s curve has already inverted— investors are concerned if a recession may be imminent and if so, how to position within portfolios?

While it’s likely the curve could invert sometime this year, there a few things investors should consider:

1. On average, markets tend to peak a year after  a sustained yield curve inversion, with a recession occurring 13 months later. This suggests investors could miss out on meaningful upside by shifting to cash even after the curve inverts initially.
   
   
2. An inverted curve does not mean monetary policy is too restrictive. Other measures like the near-term forward spread¹ or the spread between the yield on the 3-month T-bill and U.S. 10-year are still quite positive, suggesting markets and the economy can tolerate the first few rate hikes from the Fed.
   
   
3. An uncertain outlook calls for a neutral stance on duration. Further conflict in Russia/Ukraine poses even greater downside risk to the economy, suggesting holding some duration as a hedge may be warranted.
   
   

It should also be emphasized that while bear flattening is a common occurrence as the Fed begins hiking rates, long-term rates have fallen—like the brief inversion in 2019—suggesting markets may be more concerned about a potential growth scare, rather than a policy error. This is further corroborated by the fall in real yields and rise in inflation breakevens, a backdrop of looser policy. That said, the current backdrop suggests investors should remained broadly balanced within portfolios: risk assets could benefit from a potential strong late-cycle rally, while duration still serves as a useful hedge against an equity sell off.

Bear flattening is common leading up to curve inversions*
3-month change in nominal 2- and 10-yr. TSY yields prior to inversion, basis points

Source: Federal Reserve, FactSet, J.P. Morgan Asset Management. Prior to June 1976, the 1-yr. yield is substituted for the 2 yr. yield due to data availability. *Bear flattening occurs when short term rates rise faster than long term rates.
Data are as of March 7, 2022.   

[1] The near-term forward spread is the difference between the current implied forward rate (on Treasury bills) six quarters from now and the current yield on a three-month Treasury bill.

09pf221602182411