Bonds & Interest Rates · Intermediate · 4 min

The yield curve and inversions

You can read a yield curve, tell normal from flat and inverted curves, and explain why inversions are watched as a recession signal.

The curve everyone watches

Take the yields of a country's government bonds, from three months to thirty years, and connect them with a line. The result looks unremarkable. Yet it is one of the most closely watched charts in finance.

Central banks study it, economists cite it, and when its shape flips, it makes headlines. This lesson explains what the yield curve shows, what its shapes mean, and how much an inversion really tells you.

Normal, flat, inverted

The yield curve plots the yields of bonds from the same issuer, usually the government, against their maturities. Short maturities sit on the left, long ones on the right.

Normal: the curve rises. Investors usually want a higher yield to lend for longer, because more can happen to rates and inflation over many years.
Flat: short and long yields are about the same.
Inverted: short-term yields are above long-term yields. An inverted yield curve means investors accept less to lend for ten years than for three months.

Why would that happen? Short-term yields are tied closely to the central bank's current policy rate. Long-term yields reflect where investors expect rates to be over many years. An inversion usually means markets expect rates to fall in the future, often because they expect the economy to weaken and the central bank to cut.

The New York Fed has studied this for decades. Its research focuses on the spread between the 10-year Treasury yield and the 3-month Treasury bill yield. In its words, an inversion of that spread has preceded every US recession since 1960. It also notes that very low positive spreads have occurred without a recession following.

3m 5.0% > 10y 4.0%

A fictional central bank has raised its policy rate to fight inflation. Three-month bills now yield 5.0%. Investors expect rates to come down again in the coming years, so ten-year bonds yield only 4.0%.

The curve is inverted by one percentage point. That is a warning light, not a timer. Historically, recessions have followed inversions with long and varying delays, often more than a year, and stock markets have sometimes risen strongly in between.

Common mistakes

Treating an inversion as a sell signal. It says nothing precise about timing.
Comparing different issuers on one curve. A yield curve uses bonds of one issuer.
Ignoring which spread is used. 10-year minus 3-month and 10-year minus 2-year can give different signals.
Assuming the past must repeat. A good track record is not a law.

The takeaway

The yield curve shows yields by maturity. Normally it rises. When short yields exceed long ones, it is inverted, a long-watched recession signal.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the curve that is inverted.

Tap the chart.

Today's curve slopes down: short-term yields are above long-term ones. A year ago it still rose normally.
2Which spread does the New York Fed use as its main yield curve signal?

The NY Fed's research uses the 10-year minus 3-month spread to estimate recession probabilities.
3What does the New York Fed note about yield curve inversions since 1960?

Inversions have come before recessions, often by many months, and the timing varies.
4Why is a yield curve usually upward sloping?

Lending for longer means more uncertainty about rates and inflation, which investors usually want to be paid for.

of 4 correct.