The Predictive Powers of the Bond Yield Curve (2024)

The slope of the yield curve tells us how the bond market expects short-term interest rates to move in the future based on bond traders' expectations about economic activity and inflation. This yield curve is inverted on the short end. That suggests that the traders expect short-term interest rates to move lower over the next two years. Put simply, they expect a slowdown in the U.S. economy.

Types of Yield Curves

There are several distinct formations of yield curves: normal (with a steep variation), inverted, and flat. All are shown in the graph below.

Normal Yield Curve

As the orange line in the graph above indicates, anormal yield curve starts with low yields for lower maturity bonds and thenincreases for bonds with higher maturity. A normal yield curve slopes upward. When bonds reach theirhighest maturities, the yield flattens and remains consistent. This is the most common type of yield curve. Longer maturity bonds usually have a higher yield to maturity than shorter-term bonds.

For example, assume a two-year bond offers a yield of 1%, a five-year bond offers a yield of 1.8%, a 10-year bond offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%, and a 20-year bond offers a yield of 3.5%. When these points are connected on a graph, they exhibit a shape of a normal yield curve. Such a yield curve implies stable economic conditions and should prevail throughout a normal economic cycle.

Steep Yield Curve

The blue line in the graph shows a steep yield curve. It is shaped like anormal yield curve with two major differences. First, the higher maturity yields don’t flatten out at the right but continue to rise. Second, the yields are usually higher compared to the normal curve across all maturities.

Such a curve implies a growing economy moving toward a positive upturn. Such conditions are accompanied by higher inflation, which often results in higher interest rates. Lenders tend to demand high yields, which get reflected by the steep yield curve. Longer-duration bonds become risky, so the expected yields are higher.

Flat Yield Curve

A flat yield curve, also called a humped yield curve, shows similar yields across all maturities. A few intermediate maturities may have slightly higher yields, which causes a slight hump to appear along the flat curve. These humps are usually for the midterm maturities, six months to two years. The light blue line in the chart above represents a flat yield curve. In this case, there is a slight hump with modestly higher yields around maturities of six months and one year.

As the word flat suggests, there is little difference in yield to maturity among shorter- and longer-term bonds. A two-year bond could offer a yield of 6%, a five-year bond of 6.1%, a 10-year bond of 6%, and a 20-year bond of 6.05%.

Such a flat or humped yield curve implies an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown. It might appear at times when the central bank is expected to increase interest rates. In times of high uncertainty, investors demand similar yields across all maturities.

Inverted Yield Curve

The shape of the inverted yield curve, shown on the yellow line, is opposite to that of a normal yield curve. It slopes downward. An inverted yield curve means that short-term interest rates exceed long-term rates.

An inverted yield curve is rare but strongly suggestive of a severe economic slowdown. Historically, the impact of an inverted yield curve has been to warn that a recession is coming. A two-year bond might offer a yield of 5%, a five-year bond a yield of 4.5%, a 10-year bond a yield of 4%, and a 15-year bond a yield of 3.5%.

Historical Yield Curve Accuracy

Yield curves change shape as the economic situation evolves, based on developments in many macroeconomic factors like interest rates, inflation, industrial output, GDPfigures, and the balance oftrade.

Though the yield curve shouldn't be relied on to predict exact interest rate numbers and yields, closely tracking its changes helps investors to anticipate and benefit from short- to midterm changes in the economy. Additionally, the yield curve has inverted prior to each of the 10 most recent recessions, so this metric—while not a guarantee of future economic behavior—has a strong track record.

Normal curves exist for long durations, while an inverted yield curve is rare and may not show up for decades. Yield curves that change to flat and steep shapes are more frequentand have reliably precededthe expected economic cycles.

For example, the October 2007 yield curve flattened out, and a global recession followed. In late 2008, the curve became steep, which accurately indicated a growth phase of the economy following the Fed’s easing of the money supply. Most recently, in April 2022, the yield curve was normal at the short-duration end, but 10-year and two-year yields inverted. This unusual yield curve shape prompted concern among some economists and investors about the potential for an upcoming recession.

Using the Yield Curve to Invest

Interpreting a yield curve's slope is useful when makingtop-downinvestment decisions for a variety of investments. If you invest in stocks and the yield curve says to expect an economic slowdown over the next couple of years, you may consider moving your money to companies that perform well in slow economic times, such as consumer staples. If the yield curve says that interest rates should increase over the next couple of years, investment in cyclical companies such as luxury goods makers and entertainment companies makes sense.

Real estate investors can also use the yield curve. Though a slowdown in economic activity might have negative effects on current real estate prices, a dramatic steepening of the yield curve, indicating an expectation of inflation, might be interpreted to mean prices will increase in the near future.

Of course, it's also relevant to fixed-income investors in bonds, preferred stocks, or CDs. When the yield curve is becoming steep—signaling high growth and high inflation—savvy investors tend to short long-term bonds. They don't want to be locked into a return whose value will erode with rising prices. Instead, they buy short-term securities.

If the yield curve is flattening, it raises fears of high inflation and recession. Smart investors tend to take short positions in short-term securities and exchange-traded funds (ETFs) and go long on long-term securities.

You could even use the slope of the yield curve to help decide if it's time to purchase a new car. If economic activity slows, new car sales are likely to slow, and manufacturers might increase their rebates and other sales incentives.