The Yield Curve — The Bond Market's Recession Alarm

Summary

An inverted yield curve has preceded every US recession in the last 60 years. It is the single most reliable macro signal.

What the yield curve is

The yield curve plots the yield on US Treasury securities across maturities — from 3 months out to 30 years. In normal times it's upward-sloping: you get paid more for lending longer. When short-term yields exceed long-term yields, the curve is inverted.

Why inversion signals recession

Inversion means the market expects the Fed to cut rates sharply in the future — which the Fed only does when the economy is weakening. Every US recession since 1960 has been preceded by an inversion of the 10-year minus 2-year (or 10-year minus 3-month) spread, typically 6-18 months in advance.

The 10Y-2Y vs 10Y-3M

The New York Fed's preferred recession-probability model uses the 10-year minus 3-month spread. The 10Y-2Y is the more commonly quoted spread in financial media. Both have strong historical track records, though they invert at slightly different times.

Trading around the curve

The curve is a slow-moving macro variable. It's most useful for positioning — going more defensive as inversion deepens — rather than for intraday timing.

(Educational simulation only — not financial advice. Practice everything below with $100,000 virtual cash on TradeHQ.)

Key takeaways

• The yield curve is normally upward-sloping.
• Inversion has preceded every US recession since 1960.
• 10Y-3M is the NY Fed's preferred spread.
• Use the curve for regime positioning.

Check your understanding

• Inverted curve = Options: Short < long; Short > long; Flat; Negative yields. Correct answer: Short > long. Why: Short-term exceeds long-term.
• NY Fed's preferred recession spread: Options: 10Y-2Y; 10Y-3M; 30Y-5Y; 2Y-Fed Funds. Correct answer: 10Y-3M. Why: 10Y-3M used in official model.
• Since 1960, inverted 10Y-3M has preceded: Options: Some recessions; Every US recession; None; Only 2008. Correct answer: Every US recession. Why: Perfect signal in modern era.
• Curve is best used for: Options: Intraday timing; Regime positioning; Options pricing; FX. Correct answer: Regime positioning. Why: Moves slowly — regime indicator.

Sources

• NY Fed — Yield Curve Recession Probability (https://www.newyorkfed.org/research/capital_markets/ycfaq)
• FRED — T10Y2Y (https://fred.stlouisfed.org/series/T10Y2Y)

Practise this lesson

Open the practice desk and apply this lesson immediately with $100,000 in virtual cash. Concepts become usable when they are rehearsed under simulated conditions, not when they are read. Educational simulation only — not financial advice.