Yield Curve - The Term Structure of Interest Rates

By EC Assets Research Team, Macro Strategy · Published 19 May 2026 · Updated 15 June 2026

Definition

The yield curve plots the yields of government bonds across the spectrum of maturities, from the shortest (overnight, 1-month bills) to the longest (30-year bonds, sometimes 50-year in select markets). The standard US Treasury yield curve covers maturities of 1M, 3M, 6M, 1Y, 2Y, 5Y, 7Y, 10Y, 20Y, and 30Y.

The shape of the curve encodes market expectations about future short-term interest rates, inflation, and economic activity. Because government bond markets are large, liquid, and dominated by sophisticated participants, the curve is one of the most informationally efficient signals in finance. Most institutional macro analysis begins with the current shape and recent movement of the curve.

The curve is reshaped continuously as new information arrives. Rate decisions, inflation prints, employment data, geopolitical events - all produce yield curve repricing. Watching the curve respond to news is one of the primary ways professional investors gauge market reaction.

The Three Shape Categories

Movement between these shapes is itself meaningful. A curve that goes from normal to flat is signalling growth concerns; from flat to inverted is signalling near-term recession risk; from inverted back to normal (steepening) often coincides with the actual onset of recession as the Fed cuts rates.

The 2s10s Spread

The most-watched single yield curve metric is the spread between the 10-year Treasury yield and the 2-year Treasury yield (the "2s10s spread"). Its inversions have preceded every US recession since 1955:

[!key] 2s10s inversion is the most reliable recession indicator in US economic data. Eight of the last eight recessions were preceded by 2s10s inversion with lead times averaging 14 months (range: 6-24 months). The 2022 inversion was followed by sustained growth through 2024, longer than any historical precedent. Either the lead time has structurally extended due to changed monetary policy regime, or the predictive relationship has weakened. The institutional debate remains unresolved.

The New York Federal Reserve maintains a recession-probability model based on the 3-month/10-year spread that produces statistically tested predictions. The 3m10s version is technically superior to 2s10s for forecasting but the 2s10s version is more widely tracked.

What Drives Yield Curve Shape

Three forces interact to determine curve shape:

Federal Reserve policy. Short-term rates (the front of the curve) are essentially set by the Fed Funds rate. When the Fed cuts, the front falls; when it raises, the front rises. The Fed has direct control over the short end of the curve.

Inflation expectations. Long-term yields embed expected inflation over the bond's life. Rising inflation expectations push long yields up; falling expectations push them down. The 10-year breakeven inflation rate (10-year nominal minus 10-year TIPS yield) is the standard measure of market inflation expectations.

Term premium and risk preferences. The compensation investors demand for holding longer-duration bonds. Term premium can be estimated from yield curve models and tends to be positive in normal markets but compressed during QE programmes or flight-to-quality episodes.

Yield Curve and Asset Classes

Different asset classes respond differently to yield curve shape:

Common Misconceptions

"The Fed controls the entire yield curve." Only the very short end. Beyond 2 years, market forces dominate. The Fed influences long rates through QE/QT and forward guidance but does not directly control them.

"Inversion means imminent recession." Often takes 12-18 months from inversion to recession start. Acting immediately on inversion has historically been premature. The signal indicates elevated risk over the next 1-2 years, not certain near-term recession.

"Yield curve forecasts are precise." Probabilistic, not deterministic. Yield curves embed market expectations that can be wrong. The 2022-2024 period saw curves price multiple Fed cuts that never materialised; markets had over-estimated recession risk.

Historic Inversions and What Followed

The 2022 inversion is the largest and longest in the modern era without a corresponding recession through 2024. Either the lead time has structurally lengthened or the predictive relationship has weakened.

Sector Rotation Around Curve Movements

[!example] When the 2s10s curve steepens from inverted toward normal (typically signalling the end of monetary tightening), sector rotation usually follows a predictable pattern: financials outperform as net interest margins expand; cyclicals outperform as growth concerns reduce; growth stocks outperform as discount rates fall; commodities outperform as economic expansion accelerates. The 2024-2025 period saw partial steepening; financials and cyclicals partially captured this expected rotation, while growth captured most of it through AI-driven flows.

The institutional implication: yield curve shape changes are leading indicators not just of recession risk but of multi-month sector rotations within equity markets.

References

1. Fabozzi, F. J. (2021). Bond Markets, Analysis, and Strategies (10th ed.). MIT Press.
2. Tuckman, B., & Serrat, A. (2011). Fixed Income Securities (3rd ed.). Wiley.
3. Ilmanen, A. (2011). Expected Returns. Wiley.