Capital Economics has forecast further narrowing of the spread between 10-year and 2-year U.S. Treasury yields in coming months, with potential for full inversion driven by escalating tensions in the Strait of Hormuz and higher interest rate projections.

The research firm anticipates the Federal Reserve will implement 75 basis points of rate increases over the next year, compared with the roughly 40 basis points currently priced into markets. Short-term yields have risen faster than longer-term ones, propelled by stronger-than-expected economic data and energy price pressures. The 10-year yield reached 4.59 percent on Monday.

Geopolitical risks in the Strait of Hormuz have contributed to higher oil prices, with Brent crude trading between $82 and $85 a barrel. This dynamic feeds into near-term inflation expectations, lifting two-year yields while 10-year yields remain more anchored by longer-term growth outlooks. Historically, yield curve inversion has served as a reliable precursor to U.S. recessions.

The firm attributes the flattening to diverging real rate expectations, with short-term rates responding more strongly to recent labor market resilience, consumer inflation expectations at 3.7 percent, and energy costs. Softer June payroll figures have not offset these pressures.

Capital Economics’ more hawkish outlook implies markets may be underestimating the extent of required monetary tightening. The next Federal Reserve meeting on July 28-29 will provide further guidance on policy direction amid these developments.