What the yield curve is, and what it is not telling you
The yield curve gets described as a recession predictor, which oversells one part of it and skips the rest. Most days it is a picture of what lending money to the government costs at different lengths of time, and that picture drives mortgage rates, bank profits and the discount rate applied to every long-dated asset.
Reading it well means separating three things: the level of rates, the shape of the curve, and the reason the shape changed.
What the line shows
Plot the yield on government bonds against how long until they mature, from a few weeks out to thirty years, and that line is the curve. In ordinary conditions it slopes upward. Lending for longer carries more uncertainty about inflation and policy, so longer bonds pay more.
The short end reflects the central bank's policy rate and what markets expect it to be over the next year or two. The long end reflects expected average short rates over decades, plus compensation for bearing uncertainty, often called the term premium.
That split matters. When the short end moves, it usually reflects a policy expectation. When the long end moves without a policy change, something has shifted in expectations about inflation, growth, or how much investors demand to hold duration risk.
Inversion, and what it says
An inverted curve means short rates exceed long rates. The usual comparison is the 2-year against the 10-year, or the 3-month against the 10-year.
Inversion says markets expect the policy rate to be lower in the future than it is now. Since central banks cut rates when growth weakens, that expectation implies an economy that slows enough to warrant easing.
The track record is good. In the United States, the 3-month to 10-year inversion has preceded every recession since the 1960s. It has also produced a false signal, and the lag between inversion and recession has run from about six months to more than two years. A signal that is right most of the time with a variable two-year lag is interesting, and it is close to useless for timing anything.
The more useful observation is that recessions have often started after the curve re-steepens, once the central bank begins cutting. The inversion says trouble is expected. The un-inversion tends to say it has arrived.
Why the shape matters even without a recession
Three groups feel the curve directly.
Banks borrow short and lend long. Deposits reprice quickly while mortgages and commercial loans are fixed for years. A steep curve widens the spread they earn and makes lending profitable. A flat or inverted curve compresses it, and banks respond by tightening credit, which slows the economy regardless of what the recession signal says.
Borrowers face rates set at different points on the curve. Mortgage rates track the 10-year more than the policy rate, which is why a central bank can cut and mortgage rates barely move. Credit cards and floating-rate business loans follow the short end closely.
Holders of long bonds face the arithmetic of duration. A portfolio of 20-year bonds loses badly when long yields rise, whatever the curve's shape. In 2022 short and long rates both rose sharply, and long-dated government bonds fell further than many stocks.
Reading a move correctly
When the curve changes shape, the useful question is which end moved.
Bear flattening. Short rates rise faster than long. Markets are pricing tighter policy ahead, usually on stronger data or hotter inflation.
Bull flattening. Long rates fall faster than short. Investors are buying long bonds, often on weaker growth expectations or as a flight to safety.
Bear steepening. Long rates rise faster than short. Sometimes this reflects better growth expectations. It can also reflect concern about fiscal supply, since more bond issuance requires more buyers, or a rising term premium.
Bull steepening. Short rates fall faster than long, the classic pattern once a central bank starts cutting.
The same steepening can mean optimism or alarm depending on which end moved and why, which is why the direction of the curve alone is a poor summary.
What it cannot tell you
The curve prices expectations, and expectations are often wrong. Through 2021 markets priced years of low inflation and near-zero rates. That was the consensus, and it was mistaken.
It also says nothing about equities directly. Stocks have risen through inversions and fallen during steep curves. The link runs through credit conditions and earnings rather than through any mechanical relationship.
And the signal degrades when central banks own large quantities of long bonds. Quantitative easing was designed to suppress the term premium, which is the component inversion is supposed to measure. Anyone claiming a precise recession probability from one spread is overstating what the number carries.
The terms involved
Yield is the return a bond pays relative to its price. Duration is how much a bond's price moves when yields change. Spread is the gap between two rates. Tightening and easing describe the two directions of policy. Treasury securities are the bonds the curve is usually drawn from.
The archive has the questions these came from, and the glossary defines each one.
Common questions
What does an inverted yield curve mean?
That short-term government debt yields more than long-term, which is the reverse of normal. It reflects markets expecting policy rates to be lower in future than they are now. It has preceded recessions, but it is a statement about rate expectations rather than a forecast with a date attached.
What does the yield curve actually show?
The cost of lending to the government at different lengths of time. The short end tracks the policy rate and what markets expect it to be over the next year or two. The long end reflects expected average short rates over decades, plus compensation for bearing uncertainty.
Does an inverted curve always mean a recession is coming?
No. The lag has run long and varied, and the same shape can arise for different reasons. Reading it well means separating the level of rates, the shape of the curve, and why the shape changed, because a steepening driven by optimism and one driven by alarm look alike on the chart.
Guess Macro is a daily word game built on this vocabulary. Five clues, one word each.