The Bond Market May Be on the Verge of Sending a Recession Warning. Here's What the Smartest Investors Are Doing.

The yield curve -- the difference in yields between long-term and short-term bonds -- is flattening and on the verge of inverting. That's a classic recession warning that all investors need to pay attention to and act on now.

Here's the back story on the yield curve: Normally, short-term bonds should have yields below those of longer maturity bonds. That's because investors typically demand a higher return for locking up their capital for longer periods. So, if you chart yields against maturity, the yield should rise as you go out in time.

But sometimes the difference between long and short yields flattens, or even inverts, with longer-maturity bonds yielding less than shorter-term bonds. This is often measured as the difference between the yields on the two-year and 10-year Treasury securities.

The yield curve is flattening

Last week, the yield difference shrank to 17 basis points, the smallest gap since early 2025. This means the curve is flattening and, if yields continue to trend this way, will soon invert. That happens when bond investors begin to expect the Federal Reserve to hike rates to contain inflation. And it makes sense, as the Fed raised its benchmark interest rate in September and signaled that several more rate hikes are on the way.

Here's the scary part: The yield curve inverted before each of the last eight recessions (though it has occasionally inverted without a recession following). Either way, it's something investors need to prepare for now.

So, what should smart investors do just in case the yield curve inverts and a recession ensues? Here's what I'm doing. First, put away some cash. Should a recession and bear market arrive, you don't want to have to sell stocks at a loss to raise funds.

Many financial experts say you should have three to six months' cash reserves, but I know from personal experience that saving that much is not always easy or practical. Anything you can put away, in a liquid account like a high-yield savings account or money market savings account, will help you get through a contraction.

The underlying idea here is that if you're not within three years or so of retirement, you want to stay invested, because the market is very likely to recover and head higher. Also, pay down any debt -- particularly high-interest debt -- that you can. Interest rates are headed higher, which can make debt more expensive.

As for your portfolio, you can make subtle changes to add defensive stocks in sectors that tend to weather recessions better. That means utilities, healthcare, and consumer staples stocks. Finally, bond yields are soaring. The 10-year Treasury note is now yielding 5.22%. That's a great return for what is essentially a risk-free investment. So add some bonds.

The bottom line: Don't panic. Act. Get your finances in better shape and make a few portfolio changes to better weather any coming storm.

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