The Yield Curve

When economists and investors talk about “the curve”, it sounds like jargon. But there’s a simple and powerful idea behind it: the yields of bonds with different maturities reveal what the market thinks about the future of interest rates, inflation and the economy. Few indicators have warned of recessions as reliably in the past.

What the yield curve shows#

A government borrows for very different periods: three months, two years, ten years, thirty years. Each maturity has its own yield. Plot those yields side by side and you get the yield curve (or term structure of interest rates).

Why the curve normally slopes up#

Normally, long maturities pay more than short ones. There are two reasons:

1. Term premium: lending for ten or thirty years carries more risk – inflation could rise, rates could rise, and the bond’s price can swing a lot in the meantime. Investors want compensation, the term premium.
2. Expected policy rates: a ten-year yield roughly reflects the average policy rate the market expects over the next ten years. If rates are expected to rise, so does the curve.

The short end – three months to two years – closely tracks the central bank’s policy rate. The long end is set by the market: by inflation expectations, growth expectations, government borrowing and the term premium.

The inverted yield curve#

Sometimes the curve flips: short maturities yield more than long ones. That typically happens when the central bank has raised rates sharply to fight inflation – and the market expects it will soon have to cut again as the economy cools.

A common measure is the gap between 10-year and 2-year Treasury yields (“2s10s”) or between 10-year yields and 3-month bills. When it turns negative, the curve is inverted.

The track record#

In the US, every recession since the late 1960s was preceded by an inverted yield curve. That makes it one of the best-known economic indicators. But there are important caveats:

• Lead times vary widely: typically six to 24 months passed between inversion and recession, sometimes longer.
• Stocks often keep rising: after many inversions, stock markets peaked only months later. Selling at the first signal often meant missing substantial gains.
• False signals happen: the US curve was inverted for more than two years from July 2022 – the longest stretch on record. No recession followed during that period. Economists point to excess savings from the pandemic, companies and households that had locked in low rates for years, and expansive fiscal policy.

When the curve steepens again#

Interestingly, recessions often begin not during the inversion but as the curve un-inverts (“re-steepening”). That usually happens because the central bank starts cutting short-term rates – often in response to an economy that’s already weakening.

What it means for investors#

• Bond investors: with an inverted curve, short maturities pay more and carry less price risk. But if you expect falling rates, longer maturities lock in yields for longer.
• Stock investors: the curve’s shape helps judge the economic backdrop. A steep curve typically favours banks; an inverted one hints at tougher times for cyclical sectors.
• Borrowers: the curve affects whether short-term or long-term borrowing is cheaper – for example adjustable-rate versus fixed-rate mortgages.

Summary#

The yield curve plots yields across maturities. It normally slopes up because lenders want to be paid for time. When it inverts, the market expects falling rates and often a slowdown. As a warning signal, inversion has an impressive record – with lots of uncertainty about timing and the occasional false alarm. It helps you weigh risks, not find the perfect moment to sell.