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What the Yield Curve Is Warning About the EconomyBy Larry Benedict, editor, Trading With Larry Benedict The ceasefire deal between the U.S. and Iran is sending shockwaves across the markets. Stocks initially jumped as investors cheered the news, while oil prices are trading like nothing ever happened. Brent crude, a popular oil benchmark for global prices, has fallen back to levels seen just before the war erupted. As oil tankers start moving through the Strait of Hormuz, investors are letting out a sigh of relief that energy-driven inflation could be temporary. Bond yields are pulling back as well, with the 10-year Treasury yield dropping to 4.40% after rising as high as 4.67% in May. But not all interest rates are reacting the same way… and that could be a warning that the damage is already done to the economy.
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Why Short- and Long-Term Rates Aren’t Moving the Same WayAs the 10-year Treasury yield pulls back, most investors assume the reason is the drop in oil prices and reduced risk of high inflation. Longer-term yields are sensitive to inflation because bonds pay a fixed coupon payment. An increase in inflation reduces the purchasing power of those payments. So when it looks like inflation is going to be a problem, bond yields tend to rise to compensate for the loss of purchasing power. After the war broke out and oil prices jumped, the 10-year rate went from 3.97% to as high as 4.67%. But while longer-dated bond yields are now pulling back alongside oil, we’re not seeing the same reaction in shorter-term rates. For instance, the 2-year Treasury yield is trading at 4.09%. While that’s down from the recent peak, the size of the decline is much less compared to longer-dated yields. That’s important because short-term bonds are sensitive not only to inflation but to the outlook for monetary policy. In fact, the 2-year tends to precede changes in the rate set by the Federal Reserve. Vitally, this dynamic is triggering a move in one indicator that reveals recession fears.
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The Yield Curve’s WarningThe “yield curve” measures the spread between short- and long-term bond yields. Ideally, long-term yields run higher than short-term yields. The best signal for the economy is a yield curve that is positively sloped and “steep.” Low short-term rates usually mean the Fed is trying to boost the economy. In contrast, a flattening or falling yield curve means trouble is brewing. That happens when short-term rates are rising and/or long-term rates are falling. That usually reflects a combination of stricter monetary policy and fears about what that means for the growth outlook. In more blunt terms, when the yield curve turns down, it often reflects fears of slowing growth or an outright recession. Here’s the yield curve below, going back several years: 
(Click here to expand image) After peaking in February, the yield curve is turning lower as short-term rates stay higher and long-term rates drop. Short-term rates suggest inflation remains a big concern despite falling oil prices. After all, the Fed’s preferred inflation gauge – the Personal Consumption Expenditures (PCE) price index – just came in at 4.1% in May compared to last year. The core figure that excludes the impact of energy and food prices rose by 3.4%. The core PCE hasn’t been below 2% – the Fed’s target level – since early 2021. To fight inflation, it seems likely that the Fed will hold short-term rates at high levels or even raise them in the months ahead. We should take this to heart – because the real reason behind the drop in long-term rates points to growing recession fears. That means despite stock investors’ hopes, we could be in for a rocky time in the second half of 2026. Regards, Larry Benedict
Editor, Trading With Larry Benedict
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