How to Read the Yield Curve

The yield curve is a line drawn by lining up bonds of the same credit rating (usually U.S. Treasuries) by maturity and connecting the interest rate (yield) received at each maturity. The horizontal axis is maturity (3 months, 2 years, 10 years, 30 years…), and the vertical axis is the interest rate at that maturity.

The longer you lend money, the more risk you have to take on that prices may rise or conditions may worsen in the meantime. So normally, the longer the maturity, the higher the rate. Connecting these produces a line that rises from the lower left to the upper right, and this is the "normal" shape.

In one line, the yield curve is a map showing "how the price of money (interest rate) is set over time."

The shape of the curve falls broadly into three types.

① Normal (upward-sloping): long-term rates > short-term rates. This is the default shape when the economy is expected to grow smoothly.

② Flat: rates are nearly the same whether the maturity is short or long. For example, a state where the gap between the 2-year and 10-year yields nearly disappears. It usually appears when the economy is shifting from expansion to slowdown, or when the central bank is raising rates to cool overheating.

③ Inverted: short-term rates > long-term rates. A state that runs counter to common sense, where the interest on money lent short-term is higher than on money lent long-term. It arises when the market believes that "rates are high in the near future, but the economy will cool and rates will fall in the distant future."

Yield-curve inversion is famous because, historically, it has often appeared ahead of recessions.

Looking at U.S. data, the cases where the 10-year minus 2-year spread stayed persistently negative generally preceded recessions. On a 10-year minus 3-month basis, an analysis by the Federal Reserve Bank of San Francisco found that it signaled virtually every recession since 1955, with the one clear false positive being roughly once in the mid-1960s.

That said, "inversion = immediate recession" is not the case. In many instances, there was a lag of roughly 12 to 18 months between an inversion and an actual recession. For example, the curve inverted in the summer of 2006, and the U.S. Great Recession officially began about a year and a half later, at the end of 2007.

Inversion is not a prophecy that is 100% accurate. The recent past is a good counterexample.

From mid-2022, the U.S. 10-year minus 2-year curve inverted, and this inversion lasted the longest on record for the relevant statistical series (roughly about 26 months); by the summer of 2023 the spread deepened to about -1%, among the deepest in decades. The curve returned toward normal around the second half of 2024.

Yet this long inversion is being recorded as a historically rare exception that did not lead to a clear recession (at least within the usual forecasting window).

So it is right to view the yield curve as a "warning light." It turning on does not necessarily mean an accident will happen, but it is a signal that the market is worried about something. Even when looking at such indicators, what matters is the attitude of checking what actually happened in the past rather than trying to predict future prices.