What is the Yield Curve?
The yield curve plots interest rates of bonds with equal credit quality but different maturities, typically using US Treasury securities. A normal yield curve slopes upward - 3-month T-bills might yield 4.5%, 2-year notes 4.2%, 10-year notes 4.5%, and 30-year bonds 4.7%. This upward slope reflects the term premium investors demand for locking up money longer. The yield curve is updated daily and is one of the most closely watched indicators in financial markets.
Inverted Yield Curve as Recession Signal
When short-term rates exceed long-term rates, the curve inverts. An inverted yield curve has preceded every US recession since 1955, with only one false signal in the mid-1960s. The 2-year/10-year spread turned negative in July 2022 and remained inverted for over two years, one of the longest inversions on record. Historically, a recession follows inversion by 6-24 months. The mechanism is intuitive - investors accept lower long-term yields because they expect the central bank will cut rates in response to economic weakness.
Key Considerations
A flat yield curve, where short and long rates are nearly equal, often signals a transition period. A steepening curve, where long rates rise faster than short rates, typically indicates expectations of economic growth and potentially higher inflation. Bond investors use the yield curve to decide between short and long maturities. When the curve is steep, longer bonds offer significantly more yield. When flat or inverted, shorter maturities may offer better risk-adjusted returns since they carry less interest rate risk.