The yield curve is a graph that shows the interest rates (yields) on bonds of the same credit quality but different maturities — from overnight to 30 years. Usually plotted for government bonds (Treasury bonds in the US, Gilts in the UK), it is one of the most closely watched indicators in all of finance.
In normal times, the yield curve slopes upward. Longer-term bonds pay higher yields than short-term ones. This makes intuitive sense: lending money for 30 years is riskier and more uncertain than lending it overnight, so investors demand more compensation. Long-term yields also typically embed expectations of higher future inflation and interest rates.
When the yield curve flattens — when short-term and long-term yields converge — it often signals that investors expect slower growth or lower inflation ahead. When it inverts — short-term yields rise above long-term yields — it has historically been one of the most reliable predictors of recession. An inverted yield curve in 2006-2007 was an early warning of what became the 2008 financial crisis.
Why does inversion predict recession? When short-term rates (controlled by the central bank) are high and long-term rates (set by the market) are low, it suggests the market expects rates to fall in the future — because the economy is heading into a slowdown. It also squeezes bank profitability: banks borrow short-term (deposits) and lend long-term (mortgages), and when the spread between these rates compresses, lending becomes less attractive.
Investors, central bankers, and economists watch the yield curve because it aggregates the collective market judgment about future growth, inflation, and monetary policy. It is not infallible — yield curve inversions in 2022 predicted a recession that, in many economies, did not materialise — but as a signal, it has an impressive track record.