A closely watched metric for U.S. Treasury bonds is headed toward levels not seen since the early 1980s, an indication that further economic shocks are forthcoming.

The difference between the yield on the benchmark 10-year Treasury note and the 2-year note fell to negative 48 basis points on Aug. 9, when the 10-year settled at 2.80% and the 2-year reached 3.28%. The inversion — in which shorter duration yields exceed longer duration yields — is the largest it has been since August 2000.

"What the yield curve is telling you is that the market does not trust the Federal Reserve's ability to engineer a soft landing," said Patrick Leary, managing director with Loop Capital Markets. "The bond market is saying recession."

Rates rise rapidly

In order to cool demand and tame runaway inflation, the Fed has boosted its benchmark federal funds rate 225 basis points since March, a pace not seen in over 40 years.

As the central bank continues to hike rates, the yield curve will likely invert further, analysts said, boosting the probability of a severe recession.

"The curve inversion, quite simply, shows that the Fed is expected to hike rates higher in the near term than their long-term levels," said Antoine Bouvet, a senior rates strategist with ING. "I think the curve will invert further in the near term as the Fed keeps hiking and, following the same reasoning, the more the Fed hikes, the more inverted the curve."

The worsening inversion reflects high inflation, the likelihood of more rate increases in the coming months and expectations for tepid economic growth going forward, Bouvet said.

Most traders believe that the Fed will hike rates by at least another 125 basis points before the end of the year, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.

The yield curve will continue to invert as the Fed seeks to "crush inflation" by raising rates and as the economy slows, said Gennadiy Goldberg, a senior U.S. rates strategist with TD Securities.

"As the Fed continues to take rates higher in the next few months … I would expect the curve to continue inverting," Goldberg said.

The difference between the 10-year and 2-year yields could reach about 80 basis points as fears of a recession grow and inflation remains relatively high, Goldberg said. This inversion has not been that large since 1981, when inflation was at similarly high levels.

Troubling indicators

An inverted yield curve has preceded every recession for the past 50 years, although not every inversion has led automatically to a recession.

Still, inversion is a troubling indicator, said Matthew Weller, global head of research with FOREX.com and City Index.

"It signals that the economic situation is precarious and unusually vulnerable to downside shocks," Weller said. "Essentially, the market is saying that the current interest rates will likely have to be cut in the future, and the usual way that happens is through a recession."

The future direction of U.S. monetary policy depends largely on inflation data over the next few months.

"Right now, we are teetering back and forth with how high rates will go … and how long they will stay there," said John Luke Tyner, a fixed-income analyst at Aptus Capital Advisors.

Under normal conditions, the inversion could be even more striking: historically poor liquidity in the Treasury market has likely kept the current level inversion lower than it would otherwise be, said Tyner. If liquidity conditions were more normal, the 10-year yield would be as much as 35 basis points lower, putting the difference between the 10- and 2-year yields at roughly negative 80 basis points.

No recession yet

"The bottom line is that inflation is still way too high, the labor market is still healthy, and the tune of [central banks] globally, besides Japan, all support [Federal Reserve Chair Jerome] Powell in tightening policy to reduce inflation," said Tyner.

Still, while the yield curve continues to suggest a recession is nearing, stocks have rallied, consumers continue to spend and the domestic jobs market has tightened to extremes not seen since World War II as wages climb and labor demand has yet to cool.

"If this is a recession it's certainly like nothing any of us have seen before," said Leary with Loop Capital Markets.