What it is
The yield curve plots the yields of government bonds of the same credit quality against their maturities. Its shape aggregates expectations about growth, inflation and the future path of policy rates, plus a term premium that compensates holders of longer maturities for bearing uncertainty.
How it works
A normal curve slopes upward. A flat curve indicates that expectations have converged. An inverted curve, where short yields exceed long ones, implies the market expects policy rates to be cut, typically because growth is expected to weaken. The most quoted measures are the spread between the ten-year and two-year yields and the spread between the ten-year and the three-month bill.
How traders use it
Traders and allocators use the curve in several ways: as the discount rate structure underpinning equity and credit valuation, as the input to carry and roll-down calculations in fixed income, as a driver of bank net interest margins, and through curve trades that bet on steepening or flattening rather than on the level of rates. Inversion of the three-month to ten-year spread has preceded every US recession since the 1960s.
Where it breaks down
That record rests on a small number of observations, and the lag between inversion and recession has ranged from roughly six to twenty-four months, long enough that trading the signal directly is close to useless. Large-scale asset purchases and their unwind distort the term premium and complicate the interpretation. In several cycles the curve re-steepened before the downturn arrived, so it was the un-inversion, rather than the inversion, that coincided with the trouble.
Educational reference. This entry describes how a concept is defined and used. It is not investment advice, not a recommendation, and not a signal. Any rule you build from it should be tested with realistic costs before it is traded, and no historical result guarantees a future one.