Should you be concerned about the yield curve right now?

Is the yield curve flashing a warning?

Last month, we argued that the rise toward a 5% 10-year reflected growth rather than fear.

This week, we turn from the level of yields to their shape, addressing the most recent round of questions from clients.

At the broad level, the curve has done what a healthy curve should. The two-year/10-year spread was negative from July 2022 until late summer 2024, the longest inversion in the modern record, and it is now solidly positive. It got there mainly because long-term yields rose and the term premium rebuilt, not because the Fed cut aggressively.

Over the past year, the Treasury curve has generally steepened as long-term yields rose faster than short-term ones.

More recently, however, the curve briefly flattened after the Fed's September rate hike, as markets priced in additional tightening. That move has revived concerns about what a flatter curve may be signaling for stocks.

Is this a constructive flattener or a cautionary one?

A bear flattener typically occurs when the Fed is tightening and short-term yields rise faster than long-term ones. Because the front end of the curve is heavily influenced by monetary policy, it often moves first when investors expect additional rate hikes.

The long end reflects longer-term expectations for growth and inflation and may move less if investors believe the Fed will get inflation under control.

That's why a flattening curve, by itself, is an incomplete signal.

Constructive flattening:

1. Growth is strong enough that the Fed needs to tighten
2. Long-term inflation expectations stay contained
3. The market believes tighter policy will eventually succeed
4. Earnings growth remains healthy

Cautionary flattening:

1. Fed tightening tips into restrictive territory
2. Financing conditions deteriorate
3. The curve keeps flattening toward inversion

Where are we now?

Today’s environment aligns with all four parts of the constructive case.

• The S&P Global U.S. composite PMI for September was the strongest since July 2021.
• Long-run inflation expectations remained contained, with the five-year, five-year forward breakeven near 2.3%.
• Markets continue to price additional tightening without a meaningful increase in long-term inflation expectations.
• Third-quarter S&P 500 earnings are expected to grow roughly 30% year over year on revenue growth above 12%.

On the cautionary conditions, the picture is mixed but not threatening.

• Policy is edging into restrictive territory on paper. The Fed funds target of 3.75%–4.00% now sits above the 3% the Fed itself considers neutral over the longer run. With inflation still running in the mid-3% range, however, the real policy cushion is thin.
• However, financing conditions do remain open. Investment-grade spreads sit close to the tightest levels of the past several decades. High-yield spreads have widened since September, a move worth monitoring but far from stress.
• The third condition, a curve flattening toward inversion, is the one we’d weight most heavily. The two-year/10-year spread has widened since late September, and the three-month/ten-year spread, the measure most closely tied to recession risk in Federal Reserve research, sits near a full percentage point today. We believe this is not signaling caution.

Why does recession risk matter more than the level of rates?

The curve earns its place as a signal because recessions, not rates, have been the recurring threat to equities.

A common argument is that stocks have historically struggled when the 10-year Treasury has yielded 5%–6.5%. Since 1953, the S&P 500 has returned about 4% over the following 12 months and advanced only 62% of the time when Treasuries were in this range (Exhibit 1).

These numbers hold up, but they leave out the most important variable. Remove recession periods and returns in the same range rise to about 9% with an advance rate of 78%—broadly in line with other regimes.

For equities, Fed-driven flattening has historically changed the character of returns more than their direction. Return dispersion tends to rise, and quality and earnings growth tend to be rewarded. We saw that through the third quarter: The S&P 500 sits near its high while the average stock has lagged since mid-August. That extends the case for selectivity we have made in past pieces.

What would change our view?

If the risk arrives, we believe it arrives later. If flattening eventually leads to inversion, that would be a problem: The bond market would be signaling that policy has become restrictive enough to threaten growth. We’d watch three signals for that turn: the three-month/10-year spread resuming a sustained move toward zero, high-yield spreads widening persistently rather than drifting, and the labor market shifting from slow hiring to rising layoffs. Each would raise the probability of the one outcome that has historically mattered for equities. None of these signals are flashing today.

What it means for advisors

Many clients hear “flattening curve” and think “recession.” The mechanics behind curve flattening are more nuanced than that. Today's curve remains positively sloped, and the measures most closely associated with recession risk are moving away from inversion, not toward it.

The more useful question is not whether the curve is flattening, but why. The answer appears to be stronger growth, resilient earnings, and expectations for higher-for-longer policy rates rather than growing recession risk.