The yield curve and what it signals

In short

I once sat with a retired mail carrier who asked me why the news kept fussing over a line on a chart. You have probably wondered the same thing. The yield curve simply compares what the government pays to borrow money for a short time against what it pays to borrow for a long time. Normally, lenders ask for more interest the longer they lend, so the curve slopes upward. When short term rates rise above long term rates, the curve is called inverted, and people watch it as a possible warning about the economy. A warning is not a guarantee. You can find the daily numbers free on the U.S. Department of the Treasury website, under its daily Treasury par yield curve rates.

The whole of it

What it is

A friend of mine farms soybeans, and he told me once that a loan for one season costs less to carry than a loan for ten years. He is right, and that is the heart of the yield curve. The yield is the yearly interest rate a bond pays, shown as a percent of its price. The curve is a line that connects those rates for bonds of different lengths, from a few weeks out to thirty years.

The U.S. Treasury sells these bonds, and its bills, notes, and bonds are the ones most people mean. Bills last a year or less. Notes last two to ten years. Bonds last twenty or thirty. Plot the rate for each length on a chart, and you get the curve. Short on the left, long on the right.

You might picture it as a hillside. A gentle upward slope is the usual shape. A flat line means short and long rates are close. A downward slope means short rates sit above long rates, and that is the inversion that makes headlines.

How it works

If you are holding a savings account, a certificate of deposit, or a mortgage, this line touches your life more than you might think. Let me walk through why the curve takes the shape it does.

Short term rates follow the policy rate set by the Federal Reserve. When the Fed raises its target rate to cool prices, short term yields climb with it. Long term rates work differently. They reflect what buyers think will happen to growth, prices, and rates over many years. If buyers expect the economy to slow, they accept lower long term yields, since they expect rates to fall later.

So an inverted curve can mean that lenders see trouble ahead. Many economists treat it as a signal worth watching. The Federal Reserve Bank of New York publishes a recession probability model built on the gap between the ten year and three month Treasury yields. That gap is the number to know. Even so, a signal is a hint, not a promise, and timing can be far off.

Banks care about the curve, too. A bank often borrows short and lends long, so a flat or inverted curve squeezes its profit. That is one reason lending can tighten when the curve inverts. It is a quiet chain, but a real one.

The numbers, and where to find yours

I like a number I can check for myself. The Treasury Department posts its daily par yield curve rates on its website, in the section on interest rate data. The Federal Reserve Bank of St. Louis runs a free database called FRED, and it carries the same Treasury yields as simple charts. Both are primary sources, and both cost nothing.

The most watched gap is the ten year yield minus the two year yield. When that gap is below zero, the curve is inverted. Another popular gap is the ten year minus the three month yield. The New York Fed model uses that second one.

Here is what the current levels look like. The rate on the ten year note is the current figure, which the official source publishes each year, and the rate on the two year note is the current figure, which the official source publishes each year. The site fills in the verified figures with their source and date. Subtract the two year from the ten year yourself, and you have the spread.

Your own numbers matter too. If you hold a bond fund, look at its stated duration on the fund company's page. Duration tells you roughly how much the fund price moves when rates move one percentage point. A longer duration means a bigger swing.

A worked example

A woman I will call Margaret Ellis lives in Ohio and has $20,000 she plans to leave alone for a few years. She is not buying anything today. She just wants to understand what the curve is telling her.

She looks up the Treasury page on a sample day. Say the two year note yields 4.8 percent and the ten year note yields 4.2 percent. She subtracts. 4.2 percent minus 4.8 percent is negative 0.6 percentage points. The curve is inverted by 0.6 points.

Now she sees what that means in dollars. On $20,000, a 4.8 percent yield earns $20,000 times 0.048, which is $960 a year in interest. A 4.2 percent yield earns $20,000 times 0.042, which is $840 a year. The short note pays $120 more each year than the long one. That is $960 minus $840.

Margaret finds that odd at first. Normally, waiting longer pays more. Here, waiting longer pays less. She reads the inversion as lenders saying they expect rates to drop. If that happens, the long note locks in $840 a year while future short notes might pay less than $960.

Notice what she does not do. She does not treat the inversion as a countdown clock. She notes the gap, writes down the date, and checks again next quarter. She understands the curve as one clue among many. Good for her.

Where it goes wrong

I have made my share of mistakes reading signs, and the yield curve is easy to misread. Let me share the common slips so you can step around them.

The first slip is treating an inversion as a sure sign of recession. It is a pattern that has often come before downturns, but the lead time varies, and the link is not a law of nature. The lead time between an inversion and any downturn has varied, so no single reading settles the question. Read it as a caution flag.

The second slip is watching only one pair of rates. The ten year minus two year gap and the ten year minus three month gap can tell different stories on the same day. Pick one, name it, and stay consistent.

The third slip is forgetting that bond prices and yields move in opposite directions. When yields rise, existing bond prices fall. A person who needs to sell a bond before it matures may get back less than the price paid. That risk is real, and it grows with longer maturities.

The fourth slip is thinking the curve predicts the stock market or your home value. It does not. It describes borrowing costs across time. What happens to other things is a separate question.

Last, remember that the Fed shapes the short end, while buyers shape the long end. When the two pull apart, the curve bends. That bend carries meaning, but it also carries noise. Humility is a fine companion here.

Questions to answer before you leave this page

Have you looked up today's Treasury yield curve rates on the Department of the Treasury website, and do you know which two maturities you want to compare? Can you subtract the two year yield from the ten year yield and say whether the curve is sloped up, flat, or inverted? Do you know whether any bond fund or bond you own has a long duration, and how much its price might move if rates rise one percentage point? Have you checked the New York Fed recession probability page so you can see how a published model uses the curve, rather than guessing? And when you hear the word inverted on the evening news, can you now explain to a neighbor, in plain words, what it means and what it does not?