WASHINGTON (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.

An inverted yield curve occurs when short-term maturities pay a higher interest rate than longer-term maturities.

Such an unusual event typically has foreshadowed a noticeable economic downturn. Usually, a recession has followed.

Despite the warning signs in the Treasury market, however, few economists expect a recession in the next year. This time, they say, things are different.

"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 Economics said.

With an inverted yield curve, banks, hedge funds and other institutions can no longer make money by borrowing short-term money and lending it at longer terms.

The inversion first came in European trades when the 2-year note yielded 4.411% vs. a 10-year yield of 4.405%. The curve briefly inverted in late-morning and late-afternoon trading.

Treasurys continued to rally modestly throughout the session. On a day with little other news, U.S. stocks fell into negative territory as the yield curve inverted in the late morning. See Market Snapshot.

By the end of regular trading, the yield curve had normalized a bit with the 2-year yielding 4.343%, while the 10-year yield stood at 4.349%. Still, a large part of the yield curve was still inverted, with 5-year notes yielding 4.29%, just 4 basis points more than the overnight federal-funds rate of 4.25%.

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.

In a 1996 paper published by the New York Fed, economists Arturo Estrella and Frederic Mishkin concluded that the yield curve is a better predictor of recessions a year or more away than other tools, such as the index of leading economic indicators or stock prices on the New York Stock Exchange.

The yield curve's current shape implies a probability of a recession within the next four quarters of between 15% and 20%, according to Estrella and Mishkin's research. Read more.

Other economists say the curve has lost its significance because special factors, such as the government shifting issuance to shorter maturities and strong demand for Treasurys from foreign buyers, have distorted the curve's economic signals.

An inverted curve doesn't cause economic weakness by itself, 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?" added Dudley. "I don't think it is."

Federal-funds futures markets anticipate two more rate increases from the central bank, which would put the target rate at 4.75% by March.

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.

"A flattening of the yield curve is not a foolproof indicator of future weakness," Fed Chairman Alan Greenspan told lawmakers recently. He argued that several factors influence the shape of the yield curve, including expectations about monetary policy, inflation, risk and growth.

Short-term rates, such as the 2-year note, are heavily influenced by the Fed, which aggressively has raised overnight interest rates for the past 18 months. Longer-term securities, on the other hand, are more influenced by expectations about growth and risk.

Even as the Fed has pushed up yields on shorter maturities, strong demand for Treasurys from foreign buyers has held yields low on longer-term notes.

Two years ago, the yield curve was extremely steep, with 2.5 percentage points separating the yields on the 2- and 10-year notes.

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 4.2%. 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 that 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 4.291% and the 30-year was yielding 4.51%.

Rex Nutting is Washington bureau chief of MarketWatch.
Ciara Linnane is markets editor for MarketWatch in New York.

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