By Sam Goldfarb and Daniel Kruger
A closely watched barometer of economic expectations is encouraging investors to take risks again.
Yields on longer-term U.S. government debt climbed above those on shorter-term Treasurys in recent weeks -- a sign investors expect no immediate pullback in growth and inflation. That stands in contrast to earlier in the year, when longer-term yields fell below their shorter-term counterparts, a phenomenon known as an inverted yield curve.
The yield curve, in fact, completely uninverted this week for the first time since November 2018, meaning shorter-dated benchmark Treasurys all yielded less than longer-dated ones.
The reversal gives comfort to investors, because an inverted yield curve has proved to be one of financial markets' best predictors of recessions. Over the past four decades, when the yield on the 10-year Treasury has fallen below the yield on the three-month Treasury bill, U.S. economic growth has typically contracted within about a year and a half.
The 10-year yield dropped below the 3-month yield in May and stayed there for nearly five months. This past week, though, the 10-year yield climbed roughly 0.36 percentage point higher than the 3-month yield -- the largest positive gap since January. The gap between the 10-year yield and the two-year yield, meanwhile, reached roughly 0.25 percentage point, its highest level since July.
The most important development in the bond market recently has been "the un-inversion of the yield curve," said Scott Kimball, a portfolio manager at BMO Fixed Income. Earlier this year, the curve "suggested we were coming up to a recession," while it is now pointing to positive -- if hardly spectacular -- growth, he said.
Many investors said that the change in the message sent by the yield curve is the product of recent interest-rate cuts by the Federal Reserve and improvement in U.S.-China trade relations.
Taken together, the developments have bolstered expectations about the durability of the record economic expansion, helping power stocks to records. That has pushed up long-term yields, which are particularly sensitive to the outlook for economic growth and inflation. Recent interest-rate cuts by the Federal Reserve, meanwhile, have anchored short-term Treasury yields, which tend to be more responsive to central-bank policy.
Recent data has sent mixed signals about the U.S. economy. While the U.S. manufacturing sector has contracted for three consecutive months, the services sector has continued to expand. The unemployment rate is also near its lowest level in almost 50 years, though the pace of job gains has slowed recently.
A steeper yield curve has boosted bank stocks, partly because banks tend to borrow at short-term rates and lend at long-term rates. The KBW Bank Stock index has climbed 13% since the yield on the 10-year note climbed above the yield on three-month Treasurys last month. That compares with a gain of 5.3% for the S&P 500.
The rise in long-term yields relative to shorter-term ones doesn't mean the economy's in the clear, some analysts cautioned. That is because the yield curve has sometimes uninverted ahead of a recession, including the last one that started in late 2007.
Still, some investors said that the Fed's rate cuts may have been enough to forestall a recession, cushioning the economy from a slowdown in global growth or the fallout from the trade fight.
"The curve did invert, but it didn't invert long enough or deep enough to send a signal of a recession," said Donald Ellenberger, head of multisector strategies at Federated Investors.
However, such predictions are always risky, said Mr. Ellenberger, who hasn't added to holdings of more risky corporate bonds or sold safer government securities as longer-term yields have climbed.
"It's dangerous to say it is different this time," he said.
Write to Sam Goldfarb at email@example.com and Daniel Kruger at Daniel.Kruger@wsj.com