The yield curve plots interest rates across different bond maturities. When short-term rates rise above long-term ones — an "inversion" — it has historically been one of the most reliable early warnings of an oncoming recession.
The yield curve plots the interest rate (yield) on government bonds of the same issuer against how long until each bond matures — from very short maturities (like 3-month bills) out to very long ones (like 30-year bonds). Normally, it slopes gently upward: investors demand a higher yield to lock money up for longer, since longer periods carry more uncertainty about inflation and the economy.
An inversion happens when that normal relationship flips — short-term yields rise above long-term yields, producing a downward-sloping curve. This is unusual: it typically reflects the market believing the central bank (previous lesson) will be forced to cut rates in the future, usually because a slowdown or recession is coming, which pulls expected future short-term rates below today's rate.
The 2-year/10-year Treasury spread is the most widely watched inversion signal, though it isn't a perfect or immediate predictor. Historically, inversions have preceded most U.S. recessions by an average of many months to over a year — genuinely useful as an early warning, but with a long and variable lead time that makes it a poor short-term timing tool on its own.
Hypothetical Treasury yields across maturities, under two different scenarios.
| Maturity | Normal Curve Yield | Inverted Curve Yield |
|---|---|---|
| 3-Month | 3.0% | 5.2% |
| 2-Year | 3.4% | 4.8% |
| 5-Year | 3.7% | 4.3% |
| 10-Year | 4.0% | 4.0% |
| 30-Year | 4.3% | 4.2% |
In the normal scenario, yields rise steadily with maturity. In the inverted scenario, the 2-year (4.8%) yields more than the 10-year (4.0%) — the classic inversion signal, with short rates pricing in near-term tightness while long rates already reflect expectations of future cuts.
Enter a 2-year and a 10-year yield — see the spread and whether it signals a normal or inverted curve, under a simple rule.
Model: spread = 10-year yield − 2-year yield. A positive spread is a normal curve; a spread near zero is flat; a negative spread is inverted. Illustrative only — real yield curve analysis considers the full curve shape and multiple maturity pairs.
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You now understand how the bond market prices in future rate expectations. The next lesson shows how those same expectations drive currency movements and global capital flows.