Yield Curve Analysis: Inversions, Steepening & Recession Signals

Why the Yield Curve Matters

The yield curve—the relationship between bond yields and maturities—is one of the most powerful tools in macro analysis.

What it tells you:

• Market expectations for future rates
• Economic growth outlook
• Recession probability
• Fed policy expectations

Yield Curve Shapes

Normal (Upward Sloping)

• Short rates < Long rates
• Healthy economy
• Compensation for duration risk
• Most common shape

Flat

• Short rates ≈ Long rates
• Transition phase
• Often late cycle
• Watch for what comes next

Inverted

• Short rates > Long rates
• Recession warning
• Markets expect rate cuts
• Historically reliable predictor

Steep

• Large gap between short and long rates
• Often early recovery
• Fed accommodation
• Bullish for economy

Key Spreads to Monitor

10-Year Minus 3-Month

FRED Series: T10Y3M | IQ Score: 97

The Fed's preferred spread for recession prediction.

Interpretation:

Track record: Inverted before every recession since 1970. Average lead time: 12-18 months.

10-Year Minus 2-Year

FRED Series: T10Y2Y | IQ Score: 96

Most closely watched by markets.

Why traders prefer it:

• Both are actively traded
• More sensitive to near-term Fed expectations
• Can invert earlier than 10Y-3M

10-Year Minus Fed Funds

FRED Series: T10YFF | IQ Score: 95

Shows policy stance vs long-term expectations.

2-Year Minus Fed Funds

FRED Series: T2YFF

Shows near-term rate expectations vs current policy.

Inversion Mechanics

Why Curves Invert

Rate expectations channel:

• Fed raises short rates aggressively

• Markets expect slower growth

• Markets expect eventual rate cuts

• Long rates reflect future lower rates

Risk premium channel:

• Recession fears rise

• Demand for safe long-term bonds increases

• Long yields fall on flight to quality

The Reinversion Pattern

Often the recession signal isn't the initial inversion, but the subsequent steepening:

• Curve inverts (warning)

• Curve un-inverts/steepens rapidly (imminent signal)

• Recession begins shortly after

This happened in 2007, 2000, and 1990.

Real vs Nominal Curves

Nominal Yield Curve

What we typically discuss—Treasury yields.

Real Yield Curve (TIPS)

Yields minus expected inflation.

FRED Series for 5Y Real Rate: DFII5

FRED Series for 10Y Real Rate: DFII10

Why real curves matter:

• Show true borrowing costs
• Better for investment decisions
• Can diverge from nominal curves

Breakeven Inflation

Nominal yield minus TIPS yield = inflation expectations

FRED Series: T5YIE (5-year), T10YIE (10-year)

Advanced Curve Analytics

Term Premium

The extra yield for holding longer maturities, beyond rate expectations.

ACM Term Premium (NY Fed model):

• Captures compensation for interest rate risk
• Negative term premium = unusual
• Driven by QE, foreign demand, safe asset demand

Forward Rates

What the market implies about future rates.

Example: 5-year, 5-year forward rate

• The expected 5-year rate, 5 years from now
• FRED Series: FWDR5YR5YR

Curvature (Butterfly)

2s10s vs 5s = (2Y + 10Y)/2 - 5Y

Measures how "humped" the curve is.

Trading the Curve

Steepener Trades

Bet that the curve will steepen:

• Buy long end, sell short end
• Profitable when long rates rise more (or fall less)
• Often used in early recovery

Flattener Trades

Bet that the curve will flatten:

• Sell long end, buy short end
• Profitable in late cycle
• Can profit from inversion

Curve Trades in Practice

Yield Curve Data Sources

Treasury Direct Data

Daily yields for all maturities.

FRED Series

Building a Curve Dashboard

Essential Metrics

• 10Y-3M spread (recession signal)

• 10Y-2Y spread (market favorite)

• Real 10Y yield (true cost of capital)

• 10Y breakeven (inflation expectations)

Visualization Tips

• Plot the full curve daily
• Compare to historical shapes
• Track spread time series
• Add recession shading

Alert Triggers

• Inversion (spread < 0)
• Rapid steepening (>50bp in a month)
• Real rates turning positive/negative
• Breakevens at extremes

Explore all yield curve data →