What Is the Yield Curve and What Does It Signal?

What the yield curve is, the three shapes it takes, what an inversion has historically signalled and why it is a warning rather than a timer, how to read the 2s10s spread, and what it means for currencies and equities.

The yield curve is the line drawn through government bond yields at each maturity, from three months to thirty years. Its shape is a compact summary of what the market expects for growth, inflation and interest rates over the coming decade, and its inversion — short yields above long — has preceded most US recessions in modern history. It is a warning, not a timer.

Key Takeaways

• Normally, longer maturities yield more: lenders want compensation for time and uncertainty.
• The curve flattens when the market expects rates to fall in future; it inverts when short rates are above expected long-run rates.
• The 2-year/10-year spread is the standard shorthand. Negative means inverted.
• Inversion has preceded recessions with a lag ranging from months to two years. The lag is why it is not a trading signal.

Three Shapes

Why Long Yields Are Usually Higher

Lending for ten years carries more uncertainty than lending for three months — about inflation, about rates, about the borrower. The extra yield demanded for that is the term premium. Add expectations of rising rates in a growing economy, and the curve slopes up.

Why It Inverts

The short end tracks the central bank's current rate. The long end tracks where the market expects rates to settle over years. When the central bank has raised rates high to fight inflation and the market expects that to slow growth and force cuts later, the short end sits above the long end. The inversion is the market's forecast that today's rate is higher than the economy can sustain. See how interest rates work.

The 2s10s

The 10-year yield minus the 2-year yield is the most quoted measure. Positive is normal; near zero is flat; negative is inverted. The 3-month/10-year spread is an alternative that some research finds slightly more reliable. Both are on most financial data platforms.

What Inversion Has Signalled

Every US recession since the late 1960s has been preceded by an inversion of the curve, and there have been few false signals. Two caveats decide how the signal is used:

• The lag. Recessions have followed inversions by anywhere from several months to about two years. A signal with that range cannot time anything.
• The re-steepening. The curve usually un-inverts — short rates fall as cuts begin — before the recession arrives. The steepening, not the inversion, is often the closer signal.

The honest use is as context: an inverted curve means the market is pricing a slowdown, and positions that assume continued growth are taking a view the bond market disagrees with.

Worked Example: Reading Three Points

The curve is inverted throughout: 2s10s is −0.6 percentage points. The market is saying the current 5.2% is above what the economy can carry, and that rates will be lower in two years and lower still in ten. Nothing here says when.

(Illustrative levels.)

What It Means for Other Markets

• Currencies: the front end is what moves the exchange rate day to day; the curve's shape tells you how durable the current rate advantage is expected to be. See how bond yields influence global markets.
• Equities: a deep inversion is a growth warning; a rapid re-steepening has often coincided with the actual downturn. See what is index trading.
• Banks: lend long and borrow short. An inverted curve compresses their margin; bank shares tend to underperform.
• Gold: the long end minus inflation expectations is the real yield gold trades against.

What does an inverted yield curve mean?

Short-term government yields are above long-term ones. The market expects rates to be lower in future than now, usually because it expects growth to slow.

Does an inverted curve mean a recession is coming?

It has preceded most US recessions, with a lag of months to two years. It raises the probability; it does not set a date.

What is the 2s10s spread?

The 10-year yield minus the 2-year yield. Negative means inverted.

Why does the curve un-invert before a recession?

Because the central bank begins cutting short rates as growth weakens, pulling the short end below the long end again.

How does the yield curve affect forex?

Through the front end, which drives the rate differential, and through the shape, which signals how long the differential is expected to persist.

Related Reading

How interest rates work · How bond yields influence global markets · What is fixed income · What is the Federal Reserve · What is index trading