Lending for ten years normally pays more than lending for two, because more can go wrong over ten. The gap between the two is the premium demanded for that extra time, and its size is the bond market’s own opinion on the future.

When the gap disappears or reverses, that opinion has changed sharply. Short rates above long ones means the market expects conditions ahead to require lower rates than the ones in force now.

What it actually measures

A steep curve is the ordinary shape. It says growth is expected and that lenders want paying for tying money up, which is the arrangement banks are built around and the one that suits credit creation.

A flat curve removes the premium. There is no reward for lending long, which discourages the maturity transformation banks make their money from and tightens credit without any policy change.

Inversion is the reading that gets attention. It has preceded most recent recessions, and the lag between the signal and the event has ranged from months to well over a year.

The warning arrives when the curve un-inverts, not when it inverts

The upside-down curve gets treated as the alarm, and the record puts the trouble somewhere else. Downturns have generally started once the shape has righted itself, not while it was still reversed.

The reason is that re-steepening usually happens because short rates are being cut, and short rates are cut when something has broken. The inversion is the warning light; the normalisation is the engine failing.

What it does not tell you

The record is convincing and the sample is tiny. A few downturns will establish a pattern and will not support confidence about the next one, and every cycle has arrived with an argument for why it was different.

The lag is long and inconsistent. A signal that fires anywhere from six months to two years before the event cannot be used for timing anything.

Its meaning depends on why the shape changed. A curve flattening because long rates fell is a different message from one flattening because short rates rose: the first is the market downgrading the future, the second is policy doing what it was designed to do.

How to read it

Steep. The normal shape, with the market paying for duration.

Flat. Little premium left for lending long.

Inverted. The bond market’s most-watched recession signal.

Yield Curve appears on the Macro dashboard, along with Credit & Conditions, Real Yields and PMI Business Cycle.

Common questions

Why is an upside-down curve a warning?

Because it means lenders will accept less for a decade than for two years, which only makes sense if they expect rates to be far lower by then. Something has to go wrong for that to happen.

How much weight should the signal carry?

Convincing across a handful of instances, and a handful is all there is. The delay between signal and event has also ranged widely enough that nothing can be timed off it.

What does the return to normal mean?

It has been the sharper of the two warnings. Downturns have generally begun once the shape rights itself, and the shape rights itself because short rates are being cut, which happens when something has gone wrong.

Does it matter why the shape changed?

Considerably. Flattening because long rates fell says the market has downgraded growth; flattening because short rates rose says policy is doing the work. The shape is the same and the message is not.

Why does a flat curve tighten credit?

Because banks borrow short and lend long, and a flat curve removes the reward for doing so. Lending slows without any policy decision having been made, which is tightening that arrives without an announcement.