Yield Curve

The yield curve's shape — normal, inverted, flat, or steep — communicates specific and important information about the current state of monetary policy, investor expectations about future growth and inflation, and the relative risk appetite of the bond market — information that investment advisers must understand thoroughly to construct appropriate fixed income portfolios, assess economic conditions, and communicate intelligently with clients about the interest rate environment. 

The yield curve is tested as a Category 1 concept on the Series 65 examination across multiple contexts — fixed income pricing, economic analysis, monetary policy, portfolio duration management, and the interpretation of yield spreads.

The Construction of the Yield Curve

The yield curve is constructed by plotting the current market yield of each Treasury maturity on the vertical axis against the time to maturity on the horizontal axis — connecting these plotted points with a smooth curve that reveals the continuous relationship between maturity and yield across the full Treasury maturity spectrum.

The data points used to construct the standard Treasury yield curve are the on-the-run Treasury securities — the most recently issued and most actively traded benchmark issue at each maturity point — whose yields most accurately reflect current market conditions. The primary maturities plotted are the one-month, three-month, and six-month Treasury bills; the one-year, two-year, three-year, five-year, seven-year, and ten-year Treasury notes; and the twenty-year and thirty-year Treasury bonds.

The Federal Reserve H.15 statistical release — the Selected Interest Rates release — publishes Treasury yields at each of these maturities daily, providing the standardised data used by financial professionals, economists, and researchers worldwide to monitor the current state and evolution of the yield curve. The Federal Reserve Bank of New York maintains a separate yield curve model that uses the spread between the ten-year and three-month Treasury yields to calculate a monthly probability estimate of recession within the next twelve months — a widely followed quantitative application of yield curve data to economic forecasting.

The Four Shapes of the Yield Curve

The yield curve takes four recognisable shapes — each communicating different information about economic conditions and market expectations — and the interpretation of each shape is directly tested on the Series 65 examination.

The Normal Yield Curve — The Baseline Condition

The normal yield curve is upward-sloping from left to right — short-term yields are lower than long-term yields, with yields rising progressively as the maturity lengthens. This upward slope reflects two reinforcing economic forces — the expectations component and the term premium.

The expectations component reflects the market's expectation that short-term interest rates will be higher in the future than they are today — investors in long-term bonds are locking in today's rates for extended periods and require compensation for the possibility that rates will rise, eroding the relative value of the fixed coupon. The term premium is the additional yield above the pure expectations component that investors require as compensation for the risks inherent in holding long-term bonds — primarily interest rate risk, the risk that rising rates will reduce the market value of long-term fixed-rate bonds before maturity, and inflation risk, the risk that inflation will erode the purchasing power of the fixed coupon payments over the long holding period.

A normal yield curve typically characterises the expansion phase of the economic cycle — when the economy is growing at a moderate pace, inflation expectations are contained but positive, and the Federal Reserve is maintaining accommodative or neutral monetary policy. The spread between short-term and long-term yields is positive — typically ranging from one to two percentage points between the two-year and ten-year Treasury yields under normal conditions — providing healthy margins for bank lending profitability and supporting economic activity through the availability of attractively priced long-term credit.

The Inverted Yield Curve — The Recession Signal

The inverted yield curve is downward-sloping from left to right — short-term yields exceed long-term yields, with the curve sloping downward as maturity increases. This inversion is the most closely watched and most consequential yield curve shape — and its historical record as a recession predictor is remarkably consistent. The rule of thumb documented by the Federal Reserve Bank of Cleveland is that an inverted yield curve indicates a recession in approximately one year — and yield curve inversions have preceded each of the last eight recessions as defined by the National Bureau of Economic Research, with one false signal in 1967.

The mechanism through which the inverted yield curve signals recession begins with Federal Reserve monetary policy tightening. When the Fed raises short-term interest rates aggressively to combat inflation — as it did in 2022 and 2023 — the federal funds rate rises rapidly, pulling short-term Treasury yields higher in close alignment with the Fed's target rate. Long-term Treasury yields, however, are determined by the bond market's expectations of the entire future path of short-term rates over the next decade or two — and if the bond market believes the Fed's aggressive tightening will ultimately slow the economy and reduce inflation, long-term yields may rise less than short-term yields or even decline as investors anticipate that the Fed will eventually be forced to cut rates in response to economic weakness.

When the Fed raises short-term rates above the level of expected long-term rates — and the two-year Treasury yield rises above the ten-year Treasury yield — the yield curve inverts. Investors who want safety from economic uncertainty are willing to lock in the ten-year yield even at a rate below the current two-year yield because they expect short-term rates to fall substantially in the future — the present two-year rate looks attractive only temporarily before the economy weakens and rates come down. This flight to long-term safety during economic uncertainty reinforces the inversion — demand for long-term Treasury bonds drives their prices up and yields down while short-term yields remain elevated by Fed policy.

The most recent major yield curve inversion began in March 2022 when the Federal Reserve began its aggressive rate-hiking cycle, with the two-year to ten-year spread inverting substantially by mid-2022 and remaining inverted through 2023 and into 2024 — one of the longest sustained inversions in modern history. The subsequent economic trajectory following this inversion continued to be monitored closely by economists and investment professionals through 2026 as the Federal Reserve's subsequent rate reductions began the process of yield curve normalisation.

The practical investment implication of an inverted yield curve extends beyond recession forecasting — inverted yield curves reduce bank lending profitability by narrowing or eliminating the spread between short-term borrowing costs and long-term lending returns, potentially tightening credit availability and slowing economic activity through the credit channel in addition to the direct rate channel.

The Flat Yield Curve — The Transition Signal

The flat yield curve occurs when short-term and long-term yields are approximately equal across the maturity spectrum — producing a nearly horizontal curve rather than an upward or downward slope. The flat yield curve typically appears during transitions between economic phases — either during the transition from a normal curve to an inverted curve as the Fed is tightening and short-term rates are rising toward long-term levels, or during the transition from an inverted curve back toward a normal curve as the Fed begins easing and short-term rates are falling.

A flat yield curve removes the normal profitability margin of the banking system — banks that borrow at short-term rates and lend at long-term rates earn minimal spread in a flat rate environment, reducing lending activity and credit growth. The flat curve represents a period of maximum uncertainty about the future direction of both rates and economic activity — the market has no clear consensus about whether the next major move will be up or down.

The Steep Yield Curve — The Recovery Signal

The steep yield curve occurs when the spread between short-term and long-term yields is unusually large — significantly above the historical norm — with long-term yields substantially above short-term yields. Steep yield curves have historically characterised the early stages of economic recovery — when the Federal Reserve has cut short-term rates aggressively to stimulate the economy, anchoring the short end of the curve near zero or at very low levels, while long-term yields reflect rising expectations of future economic growth and inflation as the recovery gains momentum.

The 2009 through 2010 period following the global financial crisis produced one of the steepest yield curves in modern history — the Fed had cut the federal funds rate to effectively zero while ten-year Treasury yields remained in the three to four percent range, producing a two-to-ten spread exceeding two hundred and fifty basis points. This steep curve provided extremely wide lending margins for banks, supporting a gradual recovery in credit availability and economic activity following the crisis.

The Yield Curve and Monetary Policy — The Fed's Role

The Federal Reserve directly controls the short end of the yield curve through its federal funds rate target — the overnight interbank lending rate that anchors the very short maturity Treasury yields. Short-term Treasury bill yields trade in close alignment with the federal funds rate because they are nearly perfect substitutes for overnight federal funds — small differences between the two rates are rapidly arbitraged away.

The Fed has less direct control over long-term Treasury yields — the ten-year and thirty-year Treasury yields are primarily determined by the bond market's expectations of the future path of short-term rates over the relevant time horizon and by the term premium that investors require for bearing long-duration interest rate risk. During periods of conventional monetary policy — when the Fed is adjusting only the federal funds rate — the yield curve shape shifts primarily through the movement of short-term yields in response to Fed actions while long-term yields move more modestly.

During the extraordinary monetary policy period following the 2008 financial crisis and again during the 2020 COVID recession, the Federal Reserve employed quantitative easing — purchasing long-term Treasury bonds and mortgage-backed securities directly — to reduce long-term yields beyond what federal funds rate cuts alone could achieve. By directly purchasing long-term securities the Fed created additional demand that pushed long-term prices higher and yields lower, flattening or steepening the yield curve depending on the relative magnitude of short-term rate changes and long-term asset purchases.

The Two-Ten Spread — The Most Watched Yield Curve Indicator

Among all the possible spread calculations derived from Treasury yield curve data, the spread between the two-year Treasury note yield and the ten-year Treasury note yield — called the two-ten spread — is the single most widely monitored indicator of yield curve shape in financial markets. The two-ten spread is quoted in basis points — hundredths of a percentage point — and is reported in real time on financial data services throughout the trading day.

A positive two-ten spread — ten-year yield above two-year yield — indicates a normal upward-sloping curve. A negative two-ten spread — two-year yield above ten-year yield — indicates an inverted curve. The magnitude of the spread provides additional information — very large positive spreads suggest a steep curve associated with recovery conditions, very small positive spreads suggest a flat curve associated with transition or uncertainty, and any negative spread signals inversion.

An alternative recession indicator uses the spread between the ten-year Treasury yield and the three-month Treasury bill yield — favoured by some Federal Reserve economists and research institutions because the three-month bill yield is even more tightly connected to current Fed policy than the two-year yield. The New York Federal Reserve publishes a monthly recession probability estimate based on this ten-year to three-month spread — a probability above thirty percent has historically been associated with elevated recession risk.

The Yield Curve and Bond Portfolio Duration Management

The yield curve is the primary reference framework for managing duration — the interest rate sensitivity of a fixed income portfolio — and for making tactical allocation decisions within fixed income.

When the yield curve is normal and the investment adviser believes it will steepen further — long-term yields rising faster than short-term yields — a barbell strategy positions the portfolio in short-term and long-term bonds while avoiding intermediate maturities, capturing the high yield of the long end while maintaining the liquidity of the short end and limiting exposure to the intermediate maturities that underperform during steepening.

When the yield curve is expected to flatten — short-term and long-term yields converging — a bullet strategy concentrates portfolio holdings around a specific intermediate maturity that benefits from the relative yield advantage of intermediate bonds when the curve flattens.

When the yield curve inverts and the adviser expects the inversion to persist before eventual rate cuts restore a normal curve — extending portfolio duration by shifting from short-term to long-term bonds allows the portfolio to benefit from the capital appreciation that long-term bonds will experience when rates eventually fall and the curve normalises. This duration extension strategy captured extraordinary returns for investors who held long-term Treasury bonds during the Federal Reserve's rate-cutting cycles following the 2000 dot-com recession and the 2008 financial crisis.

Yield Spreads — The Credit and Sector Analysis Application

Beyond its role in economic analysis and portfolio duration management, the yield curve serves as the foundational benchmark for calculating yield spreads — the difference between the yield on non-Treasury fixed income securities and the yield on Treasury securities of comparable maturity.

Investment grade corporate bond spreads are quoted as the difference in basis points between a corporate bond's yield and the yield of the nearest-maturity on-the-run Treasury note. A ten-year investment grade corporate bond yielding five and a half percent when the ten-year Treasury yields four percent is said to trade at a spread of one hundred and fifty basis points over Treasuries. This spread represents the credit risk premium that investors demand above the risk-free Treasury rate for bearing the credit risk of the corporate issuer.

High yield bond spreads — the premium over Treasuries demanded for below-investment-grade credit — are among the most closely watched measures of credit market health and risk appetite. Widening high yield spreads signal deteriorating credit market conditions and rising fear of default — typically associated with economic stress or financial market instability. Tightening high yield spreads signal improving credit conditions and rising investor confidence — typically associated with economic expansion and supportive financial conditions.

Municipal bond tax-equivalent yield spreads compare the after-tax yield of municipal bonds to Treasury yields of comparable maturity — incorporating the federal and state income tax exemption of municipal interest under IRC Section 103 into the yield comparison to determine whether municipal bonds offer better after-tax value than comparable Treasuries for investors at specific marginal tax rates.

Examination Relevance and Key Takeaways

The yield curve is tested on the Series 65 examination extensively across multiple contexts — its construction, the four shapes and their economic interpretations, the two-ten spread as a recession indicator, the Federal Reserve's role in shaping the curve, duration management strategies, and yield spreads.

The key points to retain are these.

The yield curve plots Treasury yields across all maturities at a single point in time — from short-term bills through long-term bonds — revealing the term structure of interest rates and the market's collective expectations about future growth, inflation, and monetary policy. The normal upward-sloping curve — long-term yields above short-term yields — reflects the expectations component of future rate changes and the term premium required for bearing long-duration risk, typically characterising economic expansion with contained inflation.

The inverted yield curve — short-term yields above long-term yields — is the bond market's recession alarm, having preceded each of the last eight United States recessions with one false signal in 1967. The Federal Reserve Bank of Cleveland rule of thumb is that inversion signals recession in approximately one year. The inversion mechanism begins with Fed tightening that raises short-term rates while the market anticipates eventual rate cuts as the economy weakens, driving investors into long-term bonds and depressing long-term yields below short-term levels. The flat yield curve characterises transitions between normal and inverted conditions — representing uncertainty about future rate direction and removing bank lending profitability margins. The steep yield curve characterises early recovery — Fed has cut short-term rates aggressively while long-term yields reflect rising growth and inflation expectations.

The two-ten spread — the difference between the ten-year and two-year Treasury yields — is the most widely watched yield curve shape indicator. Positive spread equals normal curve. Negative spread equals inversion. The Federal Reserve directly controls short-term yields through the federal funds rate — long-term yields are market-determined by expectations of the future rate path and the term premium. Duration management strategies — barbell for steepening expectations, bullet for flattening expectations, duration extension for rate cut expectations following inversion — all reference the yield curve as the primary framework. Yield spreads — corporate, high yield, and municipal — are quoted as basis points above comparable-maturity Treasury yields, with the yield curve providing the risk-free benchmark against which all credit risk premiums are measured.