Why Do We Care About the Shape of the Yield Curve? What Does It Tell Us?

By Lisa James

We never really know where markets and the economy are headed, but investors and economists are constantly looking for clues. One of the most closely watched indicators is the yield curve.

Since 1966, a prolonged inversion between 3-month Treasury Bills and 10-year Treasury Notes has preceded every U.S. recession. That makes it one of the more reliable economic indicators available.

This year, the 3-month/10-year portion of the yield curve inverted for the second time, prompting widespread discussion about the increased likelihood of a recession within the next 6 to 18 months.

But what exactly is the yield curve, and why does it matter?

What Is the Yield Curve?

To understand the yield curve, consider the following example:

Imagine you're about to make two loans:

• One loan lasts three months
• The other loan lasts ten years

Would you charge the same interest rate for both?

Probably not.

There is much less uncertainty associated with a three-month loan than a ten-year loan. Because of that additional risk and uncertainty, you would likely charge a higher interest rate for the longer-term loan. Factors such as future inflation and the borrower's ability to repay would influence how much higher that rate should be.

The same concept applies to U.S. Treasury securities.

In a normal economic environment:

• A 3-month Treasury Bill typically pays a lower interest rate.
• A 10-year Treasury Note typically pays a higher interest rate.

Because the U.S. government issues debt with maturities ranging from one month to thirty years, we can plot all of these interest rates on a graph. This graph is called the yield curve.

Since U.S. Treasury debt is considered among the highest-quality debt in the world, the Treasury yield curve provides a relatively pure measure of investors' expectations regarding inflation, economic growth, and recession risk.

What Does a Normal Yield Curve Look Like?

Under normal circumstances, the yield curve slopes upward.

This means:

• Short-term interest rates are lower.
• Long-term interest rates are higher.

Investors generally demand higher compensation for lending money over longer periods because of the increased uncertainty associated with inflation, economic growth, and future market conditions.

What Causes the Yield Curve to Steepen?

A steepening yield curve occurs when the difference between short-term and long-term interest rates increases.

Why Does This Happen?

When investors become more concerned about future inflation, they demand higher interest rates for longer-term loans to compensate for the expected loss of purchasing power.

As a result:

• Long-term rates rise.
• The gap between short- and long-term rates widens.
• The yield curve steepens.

What Causes the Yield Curve to Flatten?

A flattening yield curve occurs when the difference between short-term and long-term rates narrows.

Why Does This Happen?

When inflation expectations decline or concerns about a future recession increase, investors become more willing to accept lower long-term yields.

As a result:

• Long-term rates fall.
• The spread between short- and long-term rates narrows.
• The yield curve flattens.

This steepening and flattening process serves as the market's way of expressing expectations about the future direction of the economy.

What Is an Inverted Yield Curve?

An inverted yield curve occurs when long-term interest rates fall below short-term interest rates.

In other words, investors are willing to accept lower returns for lending money over ten years than they are for lending it over a few months.

This is the opposite of what we normally expect and is often viewed as a warning sign for the economy.

What Message Does an Inverted Yield Curve Send?

There's a common saying on Wall Street:

Bull markets don't die of old age—they're often killed by the Federal Reserve.

One of the Federal Reserve's primary responsibilities is controlling inflation. When the economy grows too quickly and inflation pressures begin to build, the Fed often raises short-term interest rates.

In 2018, Federal Reserve Chairman Jerome Powell raised short-term rates four times.

Higher rates generally:

• Increase borrowing costs for businesses and consumers.
• Slow economic activity.
• Reduce demand for loans and investments.

Unfortunately, the Federal Reserve sometimes raises rates too aggressively, slowing the economy enough to trigger a recession.

Why Does an Inversion Occur?

When investors begin to believe that an economic slowdown may become a recession, they often expect future inflation to decline.

As a result:

1. Investors purchase long-term Treasury bonds.
2. Increased demand drives long-term bond prices higher.
3. Higher bond prices cause long-term yields to fall.

At the same time:

1. The Federal Reserve continues raising short-term rates.
2. Short-term yields remain elevated.

When short-term rates rise above long-term rates, the yield curve becomes inverted.

Why Do Investors Buy Long-Term Treasuries During Recession Fears?

When recession concerns grow, investors often seek safety.

They may believe:

• Businesses will struggle in a weaker economy.
• Corporate profits will decline.
• U.S. Treasury securities offer the safest place to preserve capital.

Investors also expect that, if a recession occurs, the Federal Reserve will eventually lower interest rates to stimulate economic growth.

That expectation further increases demand for long-term Treasury bonds and pushes long-term yields lower.

Eventually, Federal Reserve stimulus helps revive economic growth, and the yield curve returns to a more normal shape.

What Should Investors Watch Going Forward?

Although the yield curve has inverted twice this year, many economists believe an inversion must persist for several months before it can be considered a strong recession signal.

At the time of writing, the May inversion had lasted nearly three weeks.

Whether the inversion proves temporary or becomes more prolonged remains to be seen.

The Bottom Line

The yield curve is one of the market's most important economic indicators because it reflects investors' collective expectations about growth, inflation, and recession risk.

While no indicator is perfect, history suggests that a prolonged inverted yield curve deserves attention. For investors, it serves as an important reminder to monitor economic conditions and ensure their portfolios remain aligned with their long-term goals.

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