What Is the Yield Curve?
The yield curve is a line graph showing the interest rates paid by bonds of the same credit quality at different maturities at a single point in time. The benchmark version plots U.S. Treasury yields, from short-term bills out to 30-year bonds, because Treasuries are considered free of default risk.
In normal conditions the curve slopes upward: investors demand higher yields to lock money up for longer, compensating for inflation risk and uncertainty. The gap between long and short rates, such as the spread between 10-year and 2-year yields, is one of the most watched numbers in markets.
Reading the Yield Curve
A steep upward-sloping curve typically signals expectations of solid growth and rising rates ahead. A flat curve suggests uncertainty or a transition point in the economic cycle, with little extra reward for extending maturity.
An inverted curve, where short-term yields exceed long-term yields, is rarer and historically ominous. It usually appears when the central bank has pushed short rates high to fight inflation while investors expect rate cuts and slower growth later, and inversions of the 10-year minus 2-year spread have preceded most U.S. recessions in recent decades.
Short-maturity yields are driven mainly by central bank policy, such as the federal funds rate, while long-maturity yields reflect market expectations for growth, inflation, and the supply and demand for bonds. The curve therefore compresses an enormous amount of macro opinion into one picture.
Example
Imagine the 2-year Treasury yields 4.5 percent while the 10-year yields 3.9 percent. The 10-year minus 2-year spread is negative 0.6 percentage points, or negative 60 basis points, meaning the curve is inverted and investors are being paid more to lend for two years than for ten.
If the central bank later cuts rates and the 2-year falls to 3.0 percent while the 10-year holds at 3.9 percent, the spread flips to positive 90 basis points and the curve has re-steepened.
Why It Matters
The yield curve sets the baseline for borrowing costs across the economy, from mortgages to corporate bonds, since most debt is priced as a spread over Treasuries of a similar maturity. Its shape also drives bank profitability, because banks tend to borrow short and lend long.
On trading floors, rates desks in sales and trading live and breathe curve shape, and macro strategists use it as a leading indicator. Being able to explain a normal versus inverted curve is a classic markets interview question.
