Module 10 · Lesson 9 of 12 · Fundamentals and macro · About 5 minutes
The Yield Curve: Shape, Inversion and What It Reflects
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Before you read: Central Banks and Interest Rates: How Policy Reaches Markets
What you will learn
- How bond prices and yields move in opposite directions.
- What the yield curve plots and what normal, flat and inverted shapes look like.
- What spreads like 2s10s measure, and why steepening and flattening are described in four ways.
Why do prices and yields move opposite each other?
If new bonds pay more interest, what happens to the price of an old bond that pays less?
A bond pays fixed interest, called the coupon, and returns its face value at maturity. Its yield is the return a buyer earns at today’s price if the bond is held to maturity. If market rates rise, new bonds pay more, so an existing bond with a lower coupon is worth less: its price falls until its yield matches the market. If rates fall, the reverse happens.
Example. A fictional one-year bond pays $1,000 at maturity plus a $40 coupon. At a price of $1,000, its yield is 4%. If the price falls to $990, a buyer receives $1,040 for $990, a yield of about 5.05%.
Longer-maturity bonds’ prices usually move more for the same change in yield. This sensitivity is called duration, and it also shows up in Treasury futures prices.
What is the yield curve?
If you plot yields from three months to thirty years, what shape do you usually see?
The yield curve plots yields on bonds of the same credit quality, usually government bonds, against their maturities. The US Treasury curve runs from bills of a few weeks to 30-year bonds, and the Treasury publishes daily par yield curve rates.
- Normal (upward sloping): longer maturities yield more than shorter ones. Investors usually ask for extra yield, a term premium, to lock money up longer.
- Flat: yields are similar across maturities.
- Inverted: shorter maturities yield more than longer ones. This often happens when short rates are high because of central bank policy and markets expect rates to be lower in the future.
Yield curve diagram
Illustrative diagram constructed for teaching. Not real market data.
The diagram shows three fictional yield curves from 3 months to 30 years, one upward sloping, one flat and one inverted, with the 2s10s spread marked as a negative gap on the inverted curve. It is constructed for teaching and is not real market data.
What do curve spreads measure?
How would you sum up the shape of a curve with one number?
Traders summarize the curve with spreads between two maturities, quoted in basis points (hundredths of a percentage point):
- 2s10s: the 10-year yield minus the 2-year yield. If the 10-year yields 4.20% and the 2-year 4.50%, the spread is −30 basis points, an inversion.
- 3m10y: the 10-year yield minus the 3-month yield.
The curve steepens when the spread widens and flattens when it narrows. Commentators add how it happened:
- Bull steepening: short yields fall faster than long yields (prices rise).
- Bear steepening: long yields rise faster than short yields.
- Bull flattening: long yields fall faster than short yields.
- Bear flattening: short yields rise faster than long yields.
What does an inversion reflect?
Why do people talk about inversions before recessions?
In the United States, the curve has inverted ahead of several past recessions, which is why inversions get attention. The curve reflects expectations about policy, growth and inflation, along with term premiums and supply and demand for bonds. It is not a timer. The gap between inversion and any downturn has varied widely, and there have been inversions that were not followed by a recession soon after. A curve is a description of today’s prices.
What this does not tell you about the yield curve
- Whether or when a recession will happen.
- Where yields will go next.
- Credit risk. Corporate bond curves add a spread over government yields that depends on the issuer.
- Nothing here suggests positioning in bonds or rate futures.
Method in Practice: regime as context, logged before it's used
Fictional example. John, Harbor Index futures, the prices, times, costs and results are all invented for teaching. This shows how a written plan can be built and tested. It is not a recommendation, and nothing here says how often this idea works.
Try it on a real chart. Test this idea yourself on past sessions with bar replay. Keep your own count, including the days with no trade.
The idea. The yield curve describes interest rates across maturities. An inversion has a long history as a talking point, but no fixed timing (this lesson). John doesn't change his plan for it. He logs the regime next to every trade, so that one day he can check whether it mattered.
Three outcomes (invented numbers: this shows how to count, not how the method performs)
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Normal curve: 28 trades logged, net +$90
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Inverted curve: 14 trades logged, net −$60
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Decision: 14 trades is far too few. No rule change. Keep logging
Show the log summary
18 months, 42 trades. Normal curve (10-year minus 2-year above zero): 28 trades, +$90. Inverted: 14 trades, −$60. John's journal: "Interesting, and not evidence. I'll test it when I have 100 trades in each."
Test it yourself
- Write the regime definition (which two maturities, from which source) before logging.
- Log the regime for every trade, not just the memorable ones.
- Decide in advance how many trades you'll need before testing a rule.
Where it breaks
- Regimes last years, so you get very few of them.
- The curve's link to markets has no fixed timing.
- With small samples, a difference can be pure chance.
Reflection question: What context do you log next to your trades, and how many trades will you need before it means anything?
Check yourself
- Market rates rise. What happens to the price of an existing fixed-coupon bond? Hint: its coupon is now less attractive.
- The 10-year yields 3.90% and the 2-year 3.60%. What is the 2s10s spread, and is the curve inverted? Hint: 10-year minus 2-year, in basis points.
- Short yields rise faster than long yields. What is that called? Hint: rising yields, narrowing spread.
Reflect on your own process
- When you record a yield spread in your notes, do you write down which maturities, which data source and which day's close you used?
- What does your written plan say about how you treat headlines claiming the curve 'predicts' a recession?
- How would you check a quoted Treasury yield against the Treasury's own daily par yield curve table?
- What context do you log next to your trades, and how many trades will you need before it means anything?