The US treasury market is doing something extremely unusual

It happened in 2019 just before the 2020 pandemic recession. Before that, it happened in 2007 leading into the Great Financial Crisis. And before that, it happened in 2001 heading into the dotcom bust. We've all heard the theory: when the yield curve steepens like this, that's when the economic pain is about to begin.

So, where on earth is the recession?

Right now, the economy seems to be showing a lot of strength. Q2 GDP just came in at a solid 3% growth, indicating continued economic expansion. The stock market is also rallying with the S&P 500 hovering near all-time highs. And while unemployment has ticked up to 4.2%, that's still near historic lows. So by these three crucial metrics, the economy is strong.

So does that mean the yield curve's flawless track record as a recession forecaster has finally been broken? To understand what's happening, we have to look at how this signal works.

The yield curve measures the difference between long-term and short-term government bond yields like the 10-year and the 2-year Treasury. Normally, the curve is positive — you get paid more for locking your money up longer. This reflects expectations of a healthy, growing economy.

Inversion is when short-term yields become higher than long-term yields. It's a warning sign, usually the result of the Federal Reserve hiking short-term rates to fight inflation, which makes borrowing money expensive and chokes off economic activity.

Steepening, which is what's happening now, occurs as the curve comes out of that inversion. Historically, this is the final danger signal. It happens when the Fed starts cutting rates because it sees the economy weakening. And that's exactly what happened. The Fed cut rates three times in late 2024, causing short-term yields to fall faster than long-term ones. That's what pushed the curve out of inversion to its current level of around 0.5%.

Other indicators are also pointing to weakness

The Conference Board's Leading Economic Index fell again in June. This important metric provides an early warning sign for big shifts in the business cycle.

The manufacturing PMI has also been in contraction territory for months. This index measures the health of the manufacturing sector. Readings above 50 indicate expansion, and below 50 signal contraction. The PMI has dipped into contraction territory several times over the past two decades, often around periods of economic slowdown. Right now, it's sitting at 48, indicating a contraction.

So, if all these indicators are pointing in the same direction, why isn't the economy falling apart? The key difference this time around appears to be the US job market. When the curve first inverted back in 2022, the labour market was on fire. Job openings were higher than anything we'd seen in over 20 years, creating a massive economic buffer.

Compare that to 2007 or 2001 when the labour market was much weaker. Back then, an inverted yield curve was enough to push a fragile job market over the edge.

Today, things have cooled off. Job openings are down about 30% from their peak. The economy is more vulnerable than it was, but it's still stronger than it was before the pandemic. This unique situation — a classic yield curve signal clashing with a historically resilient labour market — creates a great deal of uncertainty.

This leaves us with the different scenarios for what could happen next

• Scenario A is the soft landing. In this scenario, the labour market holds strong. Job openings either stabilise or start to rise again. This could cause the yield curve to flatten or even reinvert, pushing the recession threat further down the road. The economy would slow to a gentle 1 to 2% growth, avoiding a full-blown contraction.
• Scenario B is the classic recession. Here, the job market continues its steady decline. This would validate the yield curve's signal. The weakening labour data would finally catch up to the bond market's warning, tipping the economy into a recession by late 2025 or early 2026. This would be a repeat of the 2007 playbook.
• Scenario C is the stagnation trap. This is a middle ground where a full recession is avoided but growth stagnates. Factors like high government spending and deglobalisation could keep the economy afloat but prevent a true recovery. In this case, the yield curve's signal isn't wrong, but its effect is muted by other powerful economic forces.

So, is the yield curve indicator broken?

Probably not. It's telling us that the traditional conditions for a recession are in place. However, the unprecedented strength of the post-pandemic labour market has created a powerful counter-narrative, potentially delaying the outcome.

The key indicator to watch now is job openings. Their direction will likely determine which of these scenarios plays out.

For investors, this means staying vigilant. At Capital.com, we’ll keep you updated on the yield curve and other key recession indicators and market trends.

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