What the yield curve is telling you
The gap between short and long-term US bond yields has a long record of turning negative before recessions. Its longest inversion on record was not followed by one. Here is how to read it.
The curve in one sentence
The yield curve plots what governments pay to borrow for different lengths of time. FinVolio tracks the most quoted version: the 10-year US Treasury yield minus the 2-year yield.
Why it is usually positive
Lending for ten years ties your money up longer and exposes you to more inflation risk than lending for two, so investors normally demand a higher yield for it. The 10-year yield sits above the 2-year, and the gap is positive.
What an inversion means
The 2-year yield tracks where investors expect the Federal Reserve’s policy rate to be over the next two years. When they expect the Fed to cut rates, usually because they expect the economy to weaken, the 10-year yield can fall below the 2-year. The gap turns negative and the curve is said to be inverted.
An inverted curve is therefore a market forecast, not a cause. It says investors collectively expect lower rates ahead.
The record
The 10-year minus 2-year curve inverted before each US recession since the late 1970s. The lead time has been long and uneven, from several months to around two years, which makes it a poor timing tool.
It also inverted in July 2022 and stayed inverted for more than two years, the longest stretch on record, and a US recession did not follow in that period. One explanation is that the inversion reflected the Fed’s rapid rate rises to fight inflation more than a coming downturn. Another is that the signal was simply weaker than its history suggested. Either way, it is a reminder that a strong record is not a guarantee.
What tends to follow
Historically, the curve has often moved back above zero shortly before or during a recession, because short-term yields fall quickly once the Fed starts cutting. Watching the steepening after an inversion has been as informative as the inversion itself.
Why Australians should watch a US measure
US bond yields set the tone for borrowing costs around the world, Australian yields follow them closely, and a US recession would reach Australia through trade, through markets and through the Australian dollar. The Australian curve exists too, but the US curve has the longer record and the larger influence.
Read it alongside other indicators, such as unemployment and credit spreads, not on its own.
General information only, not financial advice.