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NEW YORK (MarketWatch) - Treasurys were higher Tuesday after the spread between the 2-year note and the 10-year note inverted for the first time in five years.
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An inverted yield curve occurs when short-term maturities pay a higher interest rate than longer-term maturities.
Such an event has typically foreshadowed a noticeable downturn in the economy and, usually, a recession. With an inverted yield curve, banks can no longer make money by borrowing short-term money and lending it at longer terms.
The inversion first came in European trade when the 2-year note yielded 4.411% versus a 10-year yield of 4.405%. The curve briefly inverted in late morning trades, with the 2-year note yielding 4.377% and the 10-year yielding 4.373%.
Treasurys continued to rally modestly throughout the session.
In recent trades, the yield curve normalized with the 2-year yielding 4.351%, while the 10-year yield stood at 4.367%. Still, a large part of the yield curve was still inverted, with 5-year notes yielding 4.309%, just 6 basis points more than the overnight federal funds rate of 4.25%.
"The market has been pressing for curve inversion for several weeks," said economists at Action Economics, who said they expected it would be a temporary development.
The last time the yield curve inverted was in 2000, before the last U.S. recession and a period of aggressive rate cuts by the Federal Reserve. The yield curve briefly inverted in 1998 during the Asian financial crisis, the only time in the past 30 years that an inverted yield curve has not preceded a recession.
Some economists continue to eye the yield curve as a critical economic indicator. Others say it's lost its usefulness because special factors, such as the government shifting issuance to shorter maturities, have distorted the curve's economic signals.
An inverted curve doesn't cause economic weakness, although it has been correlated with weakness in the past, said Bill Dudley, an economist for Goldman Sachs. He argued that tight monetary policy is the underlying cause of most slowdowns.
"The question you have to ask is: Do you think monetary policy is really too tight?" Dudley said. "I don't think it is."
Dudley, along with most other economists, is forecasting a slight slowing of growth next year as the housing market cools. The consensus forecast calls for 3.4% growth in 2006, down from an estimated 3.6% in 2005, according to Blue Chip Economic Indicators.
The Fed too has played down the bearish implications of inversion, although "many in the market are much less prone to shrug it off," said Action Economics.
Still, "the backdrop of robust growth and benign inflation suggests that the market is not signaling a slowdown in growth which has been the case in prior curve inversions," Action said.
Federal funds futures markets anticipate two more rate increases from the Fed, which would put the target rate at 4.75% by March.
With no economic data on tap Tuesday, the market focused on supply.
The government auctioned $21 billion in 6-month notes at a discount rate of 4.20%. The bid-to-cover ratio was 1.99. The government also auctioned $23.5 billion in 3-month notes at a discount rate of 3.905%, with a bid-to-cover ratio of 2.18.
Treasury also said it would auction $20 billion of 2-year notes and $10 billion in 4-week bills later this week. The proceeds from the two auctions will be used to pay down about $16 billion in debt.
Elsewhere across the yield curve, the 5-year note was yielding 4.31% and the 30-year was yielding 4.53%.