Module III·Article III·~3 min read
Yield Curve Shapes
Fixed Income: Foundation Level
Turn this article into a podcast
Pick voices, format, length — AI generates the audio
Yield Curve: The Barometer of the Economy
Yield Curve — a graph showing the dependence of bond yields on time to maturity. This is one of the most important indicators in macroeconomics and a key tool for making investment decisions. The shape of the curve reflects market expectations regarding rates, inflation, and economic growth.
Yield Curve Shapes
| Shape | Description | Interpretation |
|---|---|---|
| Normal (upward sloping) | Long rates above short rates | Healthy economy, expectation of growth |
| Flat (flat) | Short and long rates are approximately equal | Uncertainty, transition period |
| Inverted (inverted) | Short rates above long rates | Expectation of recession in 12-18 months |
| Humped (humped) | Medium rates above short and long rates | Transition period, specific expectations |
Key Spreads for Monitoring
| Spread | Formula | Value |
|---|---|---|
| 2s10s | 10Y yield - 2Y yield | Most popular, “classic” inversion |
| 3m10y | 10Y yield - 3M T-bill | The Fed prefers this spread |
| 2s5s | 5Y yield - 2Y yield | Medium-term expectations |
| 5s30s | 30Y yield - 5Y yield | Long-term term premium |
Curve Inversion and Recessions
An inverted curve is one of the most reliable predictors of recession:
| Date of inversion (2s10s) | Start of recession | Lag |
|---|---|---|
| August 1978 | January 1980 | 17 months |
| September 1980 | July 1981 | 10 months |
| January 1989 | July 1990 | 18 months |
| February 2000 | March 2001 | 13 months |
| February 2006 | December 2007 | 22 months |
| August 2019 | February 2020 | 6 months |
| April 2022 | ??? | Awaiting |
Accuracy: 100% over the past 50 years (with a lag of 6-24 months)
Why does inversion predict recession?
- Expectations of rate cuts — the market anticipates that the Fed will ease policy due to economic weakness
- Banking mechanics — banks borrow short-term money and lend long-term. In an inversion, this is unprofitable → reduction in lending
- Self-fulfilling prophecy — companies and consumers see the inversion and become more cautious
Strategies for Different Curve Shapes
| Curve Shape | Duration | Curve positioning | Credit |
|---|---|---|---|
| Steep normal | Neutral/Long | Barbell or Ladder | Risk-on |
| Flat | Short | Bullet (medium-term) | Cautious |
| Inverted | Short duration | Short-end (high rates + safety) | Defensive, quality |
| Steepening expected | Long | Long end | Can add risk |
| Flattening expected | Short | Short end | Reduce risk |
Theories of Curve Shape
| Theory | Explanation |
|---|---|
| Expectations Theory | Long-term rates = average of expected short-term rates |
| Liquidity Preference | Investors demand a premium for long-term holding |
| Market Segmentation | Different investors prefer different maturities |
| Preferred Habitat | Combination of the previous + term premium |
Practical Application for CIO
- Monitoring 2s10s and 3m10y — daily
- Curve steepeners/flatteners — relative rates as the shape changes
- Duration matching — for liability-driven investing
- Macro signal — inversion = time to reduce risk in the portfolio
§ Act · what next