Yield Curve

What Is the Yield Curve?

The yield curve plots the yields of bonds with the same credit quality — typically US Treasuries — across different maturities. The horizontal axis represents maturities (from short-term to long-term), and the vertical axis shows the corresponding yields.

The shape of the yield curve reflects market expectations for future interest rates, inflation, and economic growth, making it one of the most important macroeconomic indicators.

Shapes of the Yield Curve

The yield curve can take several forms, each sending different economic signals:

Normal (Steep) Yield Curve

Long-term yields are above short-term yields. This is the typical shape and signals:

• Expectations of economic growth
• Expectations of rising inflation
• Compensation for the higher risk of longer maturities (term premium)

Flat Yield Curve

Short-term and long-term yields are at similar levels. This signals:

• Uncertainty about the economic outlook
• A transitional phase in monetary policy
• A potential precursor to inversion

Inverted Yield Curve

Short-term yields are above long-term yields. This is a historically reliable warning sign:

• Expectations of an economic slowdown or recession
• Expectations of future rate cuts by the Fed
• The inversion of the spread between 2-year and 10-year Treasuries (2s10s) has preceded every US recession since the 1960s

Key Spread Measures

Traders monitor various segments of the yield curve:

• 2s10s Spread: The 10-year Treasury yield minus the 2-year yield — the most widely watched indicator of inversions
• 3m10y Spread: The 10-year Treasury yield minus the 3-month yield — the Fed's preferred recession measure
• Term Premium: The additional yield investors demand for holding longer-maturity bonds

The Yield Curve as a Trading Tool

For traders, the yield curve offers several applications:

• Identifying macro regimes: The shape of the yield curve helps categorize the current economic environment
• Spread trades: Long/short positions across different maturities to profit from changes in curve shape
• Sector rotation: In a rising-yield, steepening-curve environment, financials tend to outperform while utilities lag
• Timing rate cycle turns: Curve re-steepening after an inversion often signals the beginning of a new monetary policy cycle

Frequently Asked Questions

Why is an inverted yield curve a recession signal?

An inversion signals that the market expects the central bank to cut rates in the future — typically in response to an economic slowdown. Historically, the lead time between inversion and recession has ranged from 6 to 24 months.

Which yield curve spread is most important?

The 2s10s spread is the most widely watched, but the 3m10y spread has historically shown even higher predictive power for recessions. Both should be considered together.

Can the yield curve re-steepen after an inversion without a recession following?

Theoretically yes, but in practice this has been rare. The re-steepening phase after an inversion (known as "bull steepening") often coincides with the actual onset of recession, as the Fed begins aggressively cutting short-term rates.