This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here

With the 2- to 10-year U.S. Treasury yield spread so low, a natural question arises about the potential for a recession. Levels this low are not clear signs of a recession. The mid-90s were characterized by similarly low spreads. It took half a decade until a recession happened around 2001.

However, spreads this low are concerning. Investors should closely observe developments in upcoming months. Look under the hood to the causes of the declining spread. This will allow you to decipher some of the signs better.

 
Looking at the 2- and 10-year yield separately shows the recent decline in the spread is mostly driven by an uptick of the short end of the curve, while 10-year yields have remained relatively stable throughout the last few years. While the increase in the 2-year rate -- which is historically more policy-sensitive -- is driven by expectations of a hike of the Fed funds rate, the 10-year yield remains stuck at current levels.

This lack of upward 10-year rate mobility can be explained partly by inflation expectations. Market participants observe Fed officials are leaning towards few future rate hikes, due to a lack of inflation signs. Hence, future inflation expectations remain subdued.

In addition, strong, ongoing into 2018, year’s-long demand for longer-dated bonds by the European Central Bank is key. Foreign investors, and pensions funds could be another factor weighing in on long-term yields. In sum, while it appears as if the yield curve is trying to tell us something, there are a number of indicators that send different signs.

Click here to see the completion discussion, which is part of the Zacks Economic Outlook for December.