A Tale of Two Yield Curves: Treasury Signals Clash on the Outlook

Developing a clear read on the economic outlook is challenging these days, a reality underscored by the widening split between two of the market’s most closely watched yield curves. The 10‑year/2‑year spread has been sliding lately, suggesting that the Treasury market, on the margins, expects monetary policy to remain relatively more restrictive over the intermediate horizon or that growth will weaken in the near term. The 10‑year/2‑year spread has been falling for most of the period since the war with Iran began on Feb. 28. Except for a brief interruption in February, when the spread temporarily widened, the downward bias has prevailed, resuming in August and accelerating sharply in recent weeks. It closed at +37 basis points on Friday, the lowest reading this month and not far from June’s trough of +22, which marked the lowest since early-2025. The flattening of the 10‑year/2‑year spread signals that the bond market expects economic growth and inflation to slow over the medium-term horizon. If the curve turns negative—which is looking increasingly possible—it would indicate a higher market‑based estimate of recession risk. But as with much of macro analysis these days, the picture is muddied by a variety of other factors. Consider another widely followed Treasury spread: the 10‑year yield less the 3‑month T‑bill, which has been trending higher throughout most of this year. This spread stood at +88 basis points on Friday, up roughly 60 basis points since the start of the war with Iran—and close to a four‑year high. On this front, the market is pricing in lower near‑term recession risk and expectations that the Fed will keep its target rate steady or possibly hike. The diverging yield-curve signals suggest the Treasury market is pricing two different phases of the economic outlook at once. The message is that the economy appears stable in the short run but increasingly vulnerable over a longer horizon—a classic late‑cycle configuration in which resilience today coexists with rising caution about what comes next. The latest catalyst driving this split outlook: Federal Reserve Chairman Kevin offered hawkish comments on the inflation outlook on Friday. Speaking at the Jackson Hole meeting, he said that “while this summer’s [inflation] readings were better than expected, they do not tell me that underlying trends have meaningfully improved,” and that “We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do. That’s our job, our mandate and our charge to keep.” In reaction, Fed funds futures are now pricing in a 60%-plus probability that the Fed will hike by a quarter point at the Sept. 16 FOMC meeting—flipping the script from a bias toward no change prior to Warsh’s speech. The recent divergence in the two spread trends marks a clear break from conditions that prevailed from 2023 through early this year, when spreads widened and the 10‑year/2‑year spread ran well ahead of the 10‑year/3‑month gap—a profile consistent with a strengthening economy. The reversal of the pre-Iran war trend that’s now unfolding suggests a late‑cycle shift, which may be a precursor to softer growth and tighter policy. The market could be wrong, of course, but it’s clear that the Treasury market’s outlook has shifted. The market isn’t explictly pricing in the end of the cycle, at least not yet, but it’s no longer whistling past it either. For now, the economy is maintaining its balance. But the yield curve’s split verdict suggests the calm may not last — and the market is already starting to price in that possibility. Is Recession Risk Rising? Monitor the outlook with a subscription to: The US Business Cycle Risk Report