Yield Curve
Definition
A chart plotting interest rates of bonds with equal credit quality but different maturities, whose shape (normal, flat, or inverted) signals market expectations about future economic conditions.
The yield curve plots the interest rates of US Treasury bonds across different maturities — from 1-month to 30-year. Normally, longer-term bonds pay higher rates (to compensate for the risk of locking up money longer), creating an upward-sloping curve.
An inverted yield curve — when short-term rates exceed long-term rates — has preceded every US recession in the past 50 years. It inverts when the market expects the Federal Reserve to cut rates significantly in the future, typically in response to an economic slowdown. The 2-year/10-year spread is the most watched recession indicator.
The yield curve inverted in 2022-2023 and remained inverted for a historically long period. While it correctly signaled economic stress, the anticipated recession was milder than many expected, leading to debate about whether the indicator's track record would hold in a post-pandemic economy.
A steep yield curve (big gap between short and long rates) is generally bullish — it suggests investors expect economic growth and potentially higher inflation. Banks profit from steep curves by borrowing short-term (low rates) and lending long-term (higher rates). A flat curve signals uncertainty about the economic outlook.
For investors, the yield curve affects portfolio decisions. An inverted curve makes short-term bonds and money market funds attractive (higher yields with less risk). When the curve normalizes, shifting to intermediate-term bonds can capture price appreciation as long-term rates potentially decline. The curve also influences mortgage rates, corporate borrowing costs, and equity valuations.
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Frequently Asked Questions
Does an inverted yield curve guarantee a recession?
No, but it has an impressive track record — preceding every US recession since 1969. The timing is variable (recession typically starts 6-24 months after inversion). False signals are possible but rare. It's one of the most reliable economic indicators available, though not infallible.
How does the yield curve affect mortgage rates?
Fixed mortgage rates are closely tied to the 10-year Treasury yield (not the Fed's short-term rate). When the 10-year yield rises, mortgage rates tend to follow. An inverted curve can create situations where adjustable-rate mortgages (tied to short rates) cost more than fixed-rate mortgages (tied to long rates).