• Explains how the yield curve reflects investor expectations for inflation, interest rates and economic growth
• Shows how yield curve shapes—normal, flat, inverted—signal different economic conditions and potential recessions
• Describes yield spread analysis as a tool to anticipate economic slowdowns and market reactions

The yield curve identifies changes in the economy without the need to make additional calculations. When people refer to the yield curve, they mean the graph mapping the yields of U.S. Treasury fixed-rate bills, notes and bonds on a given day.

Bonds with different maturity dates trade at different yields due to their varying interest rates. Treasury securities with the shortest terms—four weeks to 52 weeks—are called bills. Treasury notes mature in two, three, five, seven or 10 years. Treasurys with the longest terms are called bonds and mature in either 20 or 30 years.

The longer a bond’s time to maturity, the higher its interest rate is expected to be. This acts as compensation for the period when the investor’s capital is being held as a loan to the issuer. The higher interest rate accounts for the loss of purchasing power due to the eroding effects of inflation, the chance that interest rates will rise in the future and the risk that the issuer may default. The longer an investor must wait for the bond to mature, the more potential there is for their investment to lose value by one of these scenarios.

Components of the Yield Curve

The yield curve depends on three components: the interest rate, the premium for the expected rate of inflation and the bond issuer’s credit quality.

The first component is the interest rate, or coupon. This is the fixed rate the bond will pay until maturity as compensation for the investor deferring their spending. A $1,000 bond with a 4% yield will pay $40 annually in interest ($1,000 x 4% = $40). The interest rate received by the investor is a function of the supply and demand for bonds.

The second component is the premium for the expected rate of inflation. With the normal expectation that inflation will lead to higher prices on goods and services over time, longer-term bonds will pay a higher interest rate as compensation against the risk of inflation eroding the value of the investment.

The third component is generally not applicable to U.S. Treasurys because it is based on the interest rate that the market demands in relation to the issuer’s credit quality. U.S. Treasurys come the closest of any asset to being risk-free due to their backing by the U.S. government, which has never defaulted. The lower the credit quality of the issuer, the higher the bond’s interest rate should be—again, to compensate investors for the risk that they won’t see their total investment returned via the principal and coupon payments. Yield curves comprising corporate bonds, instead of the standard Treasury bonds, do incorporate credit risk.

What Shapes the Yield Curve

The normal interest rate structure of U.S. Treasurys produces an upward-sloping yield curve. (Figure 1). This is one of three basic shapes the yield curve can take based on the structure of interest rates. The other two shapes are a flat yield curve and an inverted yield curve. The steepness of the slope also varies.

The shape of the curve reveals what investors think will happen. A positive, upward-sloping yield curve is a sign of economic expansion. A negative, inverted yield curve is a harbinger of economic contraction.

The yield curve of U.S. Treasurys is correlated to expectations of economic expansion and contraction because investors adjust their preferences for bond yields based on their sentiment and forecasts.

Though prices of both bonds and stocks reflect investors’ future expectations, stocks are far more volatile and prone to false signals. As economist Paul Samuelson once famously quipped, stocks have successfully predicted nine of the last five recessions.

The inversion of the U.S. Treasury yield curve—as first studied by Campbell Harvey, a professor of finance at Duke University and director of research at the National Bureau of Economic Research (NBER)—has accurately indicated a coming recession six out of six times through the Great Recession of 2008.

Because U.S. Treasurys are essentially risk-free, their yield curve reflects their coupon rate and any adjustment for expected inflation that investors demand.

This, in combination with the millions of investors that interact with U.S. Treasurys every day—whether it is buying and selling on a daily basis or holding bonds with maturities lasting as long as 30 years—means that the Treasury yield curve tends to accurately reflect investors’ current and future expectations of the economy and inflation.

Why Inverted Yield Curves Are Important

An inverted yield curve occurs when Treasury bills and shorter-term notes have higher yields than longer-term notes and bonds (Figure 2). Because the issues have fixed interest rates, what changes in the yield calculation is the price at which investors will buy notes.

When shorter-term yields go up, it means that the prices on these bills and notes have fallen. Concurrently, prices for longer-term dated notes and bonds rise—in this case, reflecting a shift away from stocks to safer investments—pushing their yields lower. The combination of shorter-term yields rising and longer-term yields falling inverts the normally upward-sloping curve.

A variety of situations can cause investor behavior to change and subsequently invert the yield curve.

One such scenario is expecting interest rates to come down in the foreseeable future. This might happen if the Federal Reserve loosens monetary policy to encourage lending when banks may otherwise be tightening credit standards during slowing economic growth. In this situation, investors may increase their preference for bonds relative to stocks. This shift in preference occurs ahead of any actual recession.

Investors also expect the rate of inflation to decrease as demand for goods and services falls in this situation. If investors perceive that inflation won’t rise as quickly, longer-term bonds become more attractive because the risk of their coupon payments being eroded by inflation has diminished (but not completely disappeared).

A few other influential factors are international demand for U.S. Treasurys, investors’ appetite for less risky assets and low inflation from benign causes.

As Harvey first hypothesized in the 1980s, an inversion of the yield curve may precede a recession. Reality has mostly shown this to be accurate. The inverted yield curve of 2023 and 2024 has yet to be followed by a recession as of midyear 2025.

A short-term inversion of the yield curve lasting several days or a few weeks should not be construed as a signal of an impending recession. Harvey recommends that the yield curve should be inverted, on average, for one quarter or longer to truly indicate a future recession.

What a Flattening Yield Curve Signals

The yield curve flattens when interest rates across maturities become similar to each other (Figure 3). It is more common to see the yield curve flatten instead of becoming fully flat. A fully flat yield curve requires interest rates across all Treasury bills, notes and bonds to become so close that the yield curve is completely horizontal in shape.

Yield curves can flatten when there is an expected shift in the monetary regime or the economic environment. An inverted yield curve will flatten as investors believe that economic growth will accelerate in the future and/or that interest rates will rise. A normal (upward-sloping) yield curve will flatten when signs of an economic slowdown appear.

A flattening of a normal yield curve does not mean a recession is forthcoming. Long-term yields could be pushed down as investors boost allocations to bonds in response to stock market activity. The lowering of interest rates by the Fed in response to weakening economic data could also keep the economy from sputtering.

Interpreting the Yield Curve With a Spread

Harvey’s original research compared the yield difference (spread) between five- and 10-year Treasury notes to the three-month Treasury bill to determine whether the yield curve was inverted. Many others look at the spread between the 10-year note’s yield and the two-year note’s yield.

When the 10-year yield surpasses the two-year yield, the yield curve is normal and investors expect economic growth—along with its accompanying inflation—in the future. This is the typical state of the yield curve.

A negative spread between the 10-year note’s yield and the two-year note’s yield indicates that the yield curve has inverted. This signals expectations for a recession, or at least a significant economic slowdown, to occur.

Although the inverted yield curve can anticipate a recession, it does not indicate the length, depth or breadth of the potential recession. It also does not indicate a specific timeline for when the recession will start. On average, the time between a notable inversion and the onset of a recession is about one year.

S&P 500 Drops Common After Uninversion

Figure 4 demonstrates an inverse relationship since the 1980s between the S&P 500 index and the U.S. 10-2 year Treasury yield spread (the difference between the 10-year Treasury yield and the two-year Treasury yield). Jumps in the yield spread have occurred following a period of inverted yield curves—so have recessions (as designated by the red boxes in Figure 4) and drops in the S&P 500.

The timing and magnitude of the drops in the S&P 500 differ, but they have occurred. The S&P 500 fell into particularly bad bear markets following the 2000 and 2007 uninversions.

Yield Curve as a Warning Indicator

The yield curve inverts when investors foresee weaker economic conditions ahead. Though stocks are slower to react, an inverted yield curve is a warning sign to stop and look at the data. The inversion can be a signal of rougher economic and stock market conditions ahead. 

AAII recently launched a new Sentiment Investing Dashboard to help you interpret and apply sentiment indicators such as the yield curve. It includes 10+ indicators measuring investor sentiment and market sentiment, breadth, valuation and volatility. Find out more here.

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