Understanding Treasury Yield Curve Shapes

The yield curve has predicted every U.S. recession since World War II. When the 2-year/10-year spread inverted in July 2022, it stayed negative for over 26 months—the longest inversion on record (Federal Reserve Bank of St. Louis, 2024). That signal preceded economic stress, but the curve's predictive power comes with nuance: timing matters, severity matters, and the shape tells you more than a single spread number ever could.

The Four Yield Curve Shapes (And What Each Signals)

The Treasury yield curve plots interest rates across maturities from 1-month to 30-year. Its shape encodes market expectations about growth, inflation, and monetary policy. There are four primary configurations:

Normal (upward sloping): Long-term rates exceed short-term rates by 50-150 basis points. The historical 2-year/10-year spread averages approximately +80 bps since 1977 (Gurkaynak, Sack, and Wright, 2006). This shape reflects steady growth expectations and positive term premium. Why this matters: normal curves favor borrowing short and lending long—the classic banking model.

Inverted (downward sloping): Short-term rates exceed long-term rates. The 2022-2024 inversion reached approximately -100 bps at its deepest point. The point is: investors accept lower long-term yields because they expect the Fed to cut short-term rates substantially.

Flat: Minimal difference between short and long rates. Often a transitional shape appearing during Fed tightening cycles or just before inversions. The current 10-year/3-month spread of -3 bps (December 2025) indicates a near-flat curve with slightly inverted characteristics.

Humped: Mid-term rates exceed both short and long rates—the belly of the curve bulges upward. Less common, but can occur when markets expect Fed tightening in the near term followed by eventual easing.

Reading the Current Curve (December 2025)

Today's Treasury yields tell a specific story:

Source: Federal Reserve H.15 Release, December 2025

What you see: A subtle "smile" shape. Yields dip in the belly (2-5 year maturities are lower than both short-term and long-term rates), then rise significantly at the long end. The 2s10s spread sits at +8 bps—barely positive after being inverted for over two years.

What it means: The curve is transitioning from inversion back toward normal. Short rates remain elevated from Fed policy, mid-term rates reflect expected cuts, and long rates price in term premium plus long-run inflation expectations.

The durable lesson: The shape matters more than any single spread. A steepening from inverted toward normal often accompanies recessions or early recovery—not boom times.

Why the Curve Inverts (The Mechanics)

Inversion isn't random. It follows a specific pattern:

Fed tightening → Short rates rise → Expectations shift → Long rates lag

When the Federal Reserve hikes the federal funds rate aggressively (as they did from 0.00-0.25% to 5.25-5.50% between March 2022 and July 2023, a +525 bps move), short-term Treasury yields follow. But long-term yields don't rise as much because:

1. Markets anticipate eventual rate cuts (the Fed always eventually eases)
2. Growth expectations soften under restrictive policy
3. Long-term inflation expectations remain anchored around the Fed's target

The point is: inversion reflects belief that current policy is tight enough to eventually require reversal. Every inversion since the 1960s has been followed by recession within 6-18 months (Cleveland Fed, 2024).

Historical Case Studies: What the Curve Predicted

2019 Inversion and COVID Recession

The 2-year/10-year spread inverted in May 2019. Roughly 10 months later, in March 2020, the U.S. entered recession.

2006-2007 Inversion and Financial Crisis

The curve inverted in late 2006, approximately 18 months before the Great Financial Crisis accelerated. Long-duration Treasury holders benefited substantially: 10-year yields fell from 4.0% to 2.0% by December 2008, a 200 bps decline that delivered significant capital gains.

2013 Taper Tantrum: Curve Steepening

When Bernanke hinted at tapering QE in May 2013, the 10-year yield surged from 2.0% to 3.0%—a +100 bps move in 10 weeks. The curve steepened dramatically, punishing long-duration holders.

March 2020: Liquidity Crisis Distortion

During March 9-18, 2020, the 10-year Treasury yield surged +64 bps while equities collapsed (New York Fed, 2020). Foreign institutions dumped approximately $300 billion in Treasuries amid a liquidity scramble. Why this matters: even Treasuries can sell off during liquidity crises—the curve shape during stress periods reflects market dysfunction, not economic expectations.

Detection Signals: You're Likely Misreading the Curve If...

• You treat any inversion as an immediate sell signal (the lag averages 12+ months)
• You focus only on 2s10s while ignoring 10y/3m (different spreads carry different information)
• You assume a steepening curve is always bullish (steepening during recession can signal more pain ahead)
• You ignore liquidity effects during stress periods (March 2020 behavior differed from typical correlations)

Curve Shapes and Portfolio Strategy

Different shapes favor different positioning:

During inversion (expecting eventual cuts): Consider extending duration. When the Fed eventually cuts, long-term bonds outperform as prices rise. A bond with 10-year duration gains approximately 10% on a 100 bps rate decline.

During steep normal curve: Carry trades work well—borrow short, lend long. The income advantage from the upward slope compensates for some rate risk. Barbell strategies (mixing short and long maturities) generate higher convexity than bullet portfolios concentrated in intermediate terms.

During flattening: Reduce duration exposure. A flattening curve often precedes inversion and signals the end of an economic expansion.

The test: Before adjusting duration, identify where you are in the cycle. The 2022 flattening punished investors who stayed long duration—the Bloomberg US Aggregate Index lost -13.01% that year.

Breakeven Inflation and Real Yields

The Treasury curve splits into nominal and real components:

Nominal Treasury yield = Real yield + Breakeven inflation

Currently, 10-year nominal Treasury yields 3.67% while 10-year TIPS real yield is 1.45%. The difference—2.22% breakeven inflation—represents implied average inflation over the next decade. If you expect inflation above 2.22%, TIPS outperform nominals.

Checklist: Reading the Yield Curve

Essential (evaluate these first)

• Identify the current shape: Normal, inverted, flat, or humped
• Check the 2s10s and 10y/3m spreads for recession signals
• Note the current Fed funds rate to understand policy context
• Compare to the long-term average (+80 bps for 2s10s)

High-impact refinements

• Track spread changes over the past 3-6 months for momentum signals
• Compare nominal and TIPS curves to isolate inflation expectations
• During stress periods, watch for liquidity-driven dislocations rather than economic signals

Common Mistakes and How to Avoid Them

Mistake 1: Treating the curve as a timing tool

The curve inverted in July 2022 but the expansion continued into 2024. Inversions predict recessions, but with highly variable lead times. You cannot time the exact start of a downturn.

Mistake 2: Ignoring the belly of the curve

Retail portfolios disproportionately hold short and long maturities while underweighting the 5-year point. The 5-year point often moves first during policy transitions and carries important information about intermediate-term expectations.

Mistake 3: Assuming causation

The curve doesn't cause recessions—it reflects expectations. An inverted curve means tight policy and expected easing, which usually accompany economic weakness. The Fed's response to inversion (eventual cuts) affects the economy, not the curve shape itself.

Your Next Step

Pull up the current Treasury yield curve on treasury.gov or the St. Louis Fed's FRED site. Calculate the 2s10s spread and compare it to the +80 bps long-term average. This 5-minute monthly check keeps you attuned to the macro signal institutional investors monitor daily.

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Related: Spot Curves vs. Par Curves | Interpreting Steepeners and Flatteners | Key Rate Duration to Measure Curve Risk