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• The yield curve graphically represents the yields on similar bonds over different maturities.
• An inverted yield curve occurs when a short-term debt instrument has a higher yield than a longer-term instrument with the same credit risk profile.
• An inverted yield curve is unusual; it reflects bond investors' expectations for a fall in long-term interest rates, which is typically associated with a recession.
• Market participants and economists use various yield spreads as proxies for the yield curve.

Understanding the inverted yield curve

The yield curve graphically represents the yields on similar bonds over different maturities. It is also known as the term structure of interest rates. For example, the U.S. Treasury Department publishes Treasury bill and bond yields every day, and these yields can be plotted as a curve. [1]2

Analysts often distill yield curve signals into the spread between two maturities. This simplifies the task of interpreting yield curves where inversions exist between certain maturities but not others. The downside is that there is no general consensus on which spread is the most reliable indicator of recession. [3]

Typically, the yield curve slopes upward, reflecting holders of longer-term debt taking on more risk.

When long-term interest rates are lower than short-term rates, the yield curve inverts, indicating that investors are moving money from short-term bonds to long-term bonds. This suggests that the market as a whole has become more pessimistic about the near-term economic outlook.

In modern times, this inversion has become a relatively reliable indicator of recession. [4]5 Because yield curve inversions are relatively rare but typically occur before a recession, they are often closely watched by financial market participants.

IMPORTANT NOTE: An inverted Treasury yield curve is one of the most reliable leading indicators of a recession.

Choose your spread

Academic research on the relationship between an inverted yield curve and recessions tends to focus on the spread between the 10-year Treasury yield and the 3-month Treasury note, while market participants focus more on the yield spread between the 10-year and 2-year bonds. [4]

Federal Reserve Chairman Jerome Powell said in March 2022 that he prefers to measure recession risk by focusing on the difference between the current three-month Treasury bill rate and derivatives market pricing predicting the same rate 18 months from now. [6]7

Historical examples of inverted yield curves

The spread between the 10-year and the 2-year Treasury note has been a generally reliable recession indicator since a false positive in the mid-1960s. [8] This has not stopped a long list of senior U.S. economic officials from underestimating their forecasting capabilities for years. [9]

In 1998, after Russia defaulted on its debt, the 10-year/2-year spread briefly inverted. The Federal Reserve's rapid interest rate cuts helped stave off a U.S. recession.

Note: While an inverted yield curve has typically preceded a recession in recent decades, it does not cause one. Instead, bond prices reflect investors' expectations that long-term yields will fall, which typically occurs in recessions.

In 2006, interest rate spreads were inverted for much of the year. Long-term Treasury bonds outperformed stocks in 2007. The Great Recession began in December 2007.

On August 28, 2019, the 10-year/2-year interest rate spread briefly turned negative. The U.S. economy experienced a two-month recession in February and March 2020 due to the COVID-19 outbreak, which would not have been factored into bond prices six months ago.

At the end of 2022, against the backdrop of high inflation, the yield curve inverted again.

As of December 4, 2023, the Treasury yields are as follows:

• Three-month Treasury bond yield: 4.31% -Two-year Treasury bond yield: 4.56%
• 10-year Treasury bond yield: 4.22%
• 30-year Treasury bond yield: 4.40%10

As shown above, the 10-year Treasury bond rate is 0.26 percentage points lower than the 2-year yield. Although the inverted yield curve begins to narrow in 2022, it is still inverted.

https://www.ustreasuryyieldcurve.com/

The state of the yield curve reflects investors' views on the state of the economy and whether the Federal Reserve will continue to raise interest rates. Or maybe not.

Many economists believe the U.S. economy may still be headed for recession. However, others believe that the narrowing of the inverted yield curve through December 2023 is telling a different story. Some say the yield curve may signal investor confidence that rocketing inflation has been brought under control and normalcy will return, rather than signaling economic turmoil.

What is the yield curve?

The yield curve is a line that plots the yields (interest rates) on bonds of the same credit quality but different maturities. The yield curve that gets the most attention is that of U.S. Treasury bonds.

What can an inverted yield curve tell investors?

Historically, a long-term inversion of the U.S. yield curve has heralded a recession. An inverted yield curve reflects investor expectations that long-term interest rates will fall as economic performance worsens.

Why is the spread between 10-year and 2-year rates so important?

Many investors use the spread between the 10-year and 2-year Treasury yields as a proxy for the yield curve, and in recent decades it has been a relatively reliable leading indicator of recessions. Some Fed officials believe that focusing on the short term is a better indicator of the likelihood of a recession.

Bottom line

Regardless of which yield spread you use as a proxy, a long-term inverted yield curve appears to be a more reliable predictor of recession than a short-term inverted yield curve.

Fortunately, recessions are rare events and we don't have enough experience yet to draw firm conclusions. As one Fed researcher noted, "It's hard to predict recessions. We haven't had many recessions, and we don't fully understand the causes of the ones we've had. Still, we keep trying." 3

References

[1] U.S. Department of the Treasury. “Interest Rate Statistics.”

[2] YieldCurve.com. “Market Yield Curve Page.”

[3] Federal Reserve System, FEDS Notes. “There Is No Single Best Predictor of Recessions.”

[4] Federal Reserve Bank of Chicago. “Why Does the Yield-Curve Slope Predict Recessions?”

[5] Federal Reserve Bank of Boston. “Predicting Recessions Using the Yield Curve: The Role of the Stance of Monetary Policy.”

[6] Bloomberg. “Powell Says Look at Short-Term Treasury Yield Curve for Recession Risk.”

[7] C-SPAN. “National Association for Business Economics Conference, Federal Reserve Chair Jay Powell.” Play video at 59:00 mark.

[8] FRED (Federal Reserve Economic Data), Federal Reserve Bank of St. Louis. “10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity.” Select “Max” as date range.

[9] Dario Perkins on Twitter. “A Short History of Yield Curve Denial.”

[10] YCharts. https://ycharts.com/indicators/reports/daily_treasury_yield_curve_rates?

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