What Is the Yield Curve? How It Works and Types

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The yield curve is a line that plots the yields of bonds with the same credit quality against their time to maturity, from the shortest to the longest. Its shape, whether rising, flat or falling, shows how much more (or less) investors demand to lend money for longer periods. The curve almost everyone means by “the yield curve” is built from U.S. Treasury securities. Treasurys carry no meaningful credit risk, so the differences between their yields reflect time and expectations rather than default risk.

What Is the Yield Curve?

Each point on the curve is the annual return the market requires to lend for that length of time. A 3-month Treasury bill, a 2-year note, a 10-year note and a 30-year bond each have their own yield. Connect those points and you get the curve.

Holding credit quality constant isolates maturity. If you mixed a 2-year Treasury with a 10-year junk bond, the gap between them would mostly reflect default risk, not time. Separate curves exist for other borrowers of similar risk, such as AA-rated corporate bonds or a country’s government debt, and the U.S. Treasury curve is the benchmark they are measured against.

The yields plotted are typically yield to maturity figures: the annualized return an investor earns by buying at today’s price and holding until the bond matures.

How the Yield Curve Works

What sets each part of the curve

The short end (bills and notes maturing within about two years) moves closely with the central bank’s policy rate. In the U.S., that is the federal funds rate set by the Federal Reserve. When the Fed raises its target, short-term Treasury yields usually rise with it, because a 3-month bill competes directly with overnight and short-term money markets.

The long end (10-year and 30-year maturities) is set more by markets than by the central bank. It reflects what investors expect for inflation, economic growth and the path of short-term rates over many years, along with a term premium. The term premium is extra yield for tying up money longer and accepting larger price swings.

Why the curve normally slopes upward

Several standard theories explain the shape, and each captures part of the picture:

• Expectations theory: long-term yields are roughly an average of expected future short-term rates. If investors expect rates to rise, long yields sit above short yields.
• Liquidity preference theory: investors prefer shorter, more liquid holdings and must be paid a premium to lend long. This adds an upward tilt even when rates are expected to stay flat.
• Market segmentation (preferred habitat): different buyers favor different maturities. Pension funds and insurers matching long-dated liabilities favor long bonds, and money market funds favor bills. Supply and demand within each segment affect yields there.

Implied forward rates: a worked example

Expectations theory lets you read the market’s implied future rates from the curve. Hypothetical example, assuming annual compounding and no term premium:

• 1-year yield: 3.00%
• 2-year yield: 4.00%

Investing for two years at 4% grows $1 to 1.04 × 1.04 = $1.0816. Investing for one year at 3% grows it to $1.03. For the two strategies to break even, the one-year rate starting a year from now must satisfy 1.03 × (1 + f) = 1.0816, so f ≈ 5.01%.

The upward slope implies the market expects one-year rates to rise to about 5% next year. In practice, part of that gap is term premium rather than a pure rate forecast, which is why forward rates are imperfect predictions.

Measuring the slope

To track the curve over time, analysts reduce it to a spread between two maturities:

Spread = long-maturity yield − short-maturity yield

The most widely followed is the 10-year yield minus the 2-year yield. A negative result means that segment of the curve is inverted. Another common measure is the 10-year minus the 3-month yield.

Hypothetical curve on one day:

The 10-year minus 2-year spread is +0.30 percentage points (30 basis points), so that measure says the curve is upward sloping. The 10-year minus 3-month spread is −0.10 percentage points, so that measure says the curve is inverted. Both are correct for their segment, so “the curve is inverted” means little until you know which two maturities are being compared.

Types of Yield Curves

Normal (upward-sloping) yield curve

Short-term yields are lower than long-term yields, and the line rises from left to right. This is the Treasury curve’s most common shape historically and is associated with an expanding economy, though it mainly says the market expects rates to stay steady or rise and requires a positive term premium. Hypothetical normal curve: 2-year at 1.0%, 5-year at 1.8%, 10-year at 2.5%, 20-year at 3.5%.

Steep yield curve

A steep curve is an upward-sloping curve with an unusually wide gap between short and long yields. It typically appears when markets expect strong growth and rising inflation, so investors demand much more compensation for long-term debt whose real value inflation could erode. Steep curves often emerge early in a recovery, when the central bank holds short rates low while long yields rise.

Flat yield curve

Yields are similar across maturities. Hypothetical flat curve: 2-year at 6.0%, 5-year at 6.1%, 10-year at 6.0%, 20-year at 6.05%. A flat curve signals uncertainty about the economy’s direction and often appears during transitions. Flattening describes the gap narrowing over time, either because long rates fall relative to short rates or because short rates rise faster during central bank tightening.

Inverted (downward-sloping) yield curve

Short-term yields exceed long-term yields. Two forces usually combine. A central bank that has raised short rates sharply pushes the short end up. Investors who expect slower growth, lower inflation and eventual rate cuts lock in long-term yields, and their buying raises long-bond prices and lowers long yields. Inversions are less common than upward-sloping curves and have historically been watched as a recession warning.

Humped (bell-shaped) yield curve

Medium-term yields, often around two to five years, sit above both short and long yields. This shape can reflect expectations of near-term rate increases followed by a slowdown or falling inflation later. Analysts often treat it as a transitional state between a normal and an inverted curve.

Double-hump (camel) yield curve

A rarer shape with two peaks. It suggests that short-term policy actions, medium-term forecasts and long-term factors are pulling different parts of the curve in different directions, and it typically reflects significant disagreement about the outlook.

The U.S. Treasury Yield Curve

The Treasury curve links short-term bills with longer-term notes and bonds. The U.S. Department of the Treasury publishes daily yield curve rates for each trading day, generally by 6:00 p.m. Eastern time. The most cited maturities are the 3-month, 2-year, 5-year, 10-year and 30-year.

The Treasury curve is the benchmark for U.S. credit markets. Banks and lenders use it as a reference when setting lending and savings rates. Mortgage rates track longer Treasury yields, especially the 10-year, plus a spread. Corporate bond yields are commonly quoted as a spread over the Treasury of similar maturity.

How Investors Use the Yield Curve

Reading the economic outlook. The curve compresses market expectations about rates, inflation and growth into one picture. An investor who sees the curve flattening toward inversion might shift toward defensive assets that have tended to hold up in recessions. A rapidly steepening curve that signals rising inflation expectations might lead an investor to avoid long-term bonds, whose fixed payments lose purchasing power as prices rise.

Choosing maturities. The slope shows how much extra yield an investor gets for extending maturity. On a steep curve, moving from a 2-year to a 10-year note may add meaningful income. On a flat or inverted curve, it adds little or nothing while still adding price risk.

Riding the curve (roll-down). On an upward-sloping curve, a bond’s yield tends to fall as it ages toward maturity, because it is priced against shorter, lower-yielding maturities, so its price rises. An investor can buy a bond, hold it as it “rolls down” the curve and sell before maturity to capture that gain. This works only if the curve stays roughly stable, since a rise in rates can erase the gain.

Benchmarking credit. Comparing a corporate or municipal bond’s yield with the Treasury curve at the same maturity isolates its credit spread, the extra compensation for that issuer’s default risk.

Yield Curve Risk

Yield curve risk is the risk that a change in interest rates, or in the curve’s shape, reduces the value of fixed-income holdings. Because bond prices move inversely to yields, rising market yields push existing lower-coupon bonds down in price on the secondary market, and falling yields push prices up.

The curve rarely moves in perfect parallel. In a steepening, long yields rise relative to short yields, which hurts holders of long bonds most. A portfolio concentrated at one point on the curve is exposed to moves at that maturity. Duration measures how sensitive a bond is to yield changes, and longer maturities generally carry more of it.

The Yield Curve as a Recession Signal

The 10-year minus 2-year spread turned negative in 2006, ahead of the 2008 financial crisis and the recession that accompanied it, and inversions have preceded other U.S. recessions as well. That record made inversion one of the most cited recession indicators.

The relationship has been questioned. In December 2017, with the curve flattening, then Fed Chair Janet Yellen said that while there is a strong historical correlation between inversions and recessions, correlation is not causation. She added that the link between the curve’s slope and the business cycle may have changed.

Events since then complicated the picture further. The curve inverted briefly in early 2020 and then steepened in 2021 after the Fed cut rates to near zero and bought bonds in large volumes during the pandemic. In 2022, the Fed raised rates aggressively to fight inflation. Short yields climbed faster than long yields, and the 2-year and 10-year inverted. The curve stayed inverted through 2023 and into the third quarter of 2024, a period in which the economy kept growing, unemployment stayed relatively low and inflation trended down.

Limitations of the Yield Curve

• Timing is vague. Even when an inversion has preceded a recession, the lag between the two has varied, so the signal cannot pinpoint when a downturn might start.
• The term premium distorts the forecast. Long yields mix rate expectations with a term premium. Large bond purchases by central banks, or heavy foreign demand for Treasurys, can push long yields down without any change in the growth outlook.
• A snapshot is not a trend. The direction of change (steepening or flattening) and why it is happening often matter more than a single day’s shape.

Distinctions Readers Often Confuse

Yield curve vs. term structure of interest rates. These mean the same thing. The term structure is the relationship between rates and maturities, and the yield curve is its graph. Some textbooks reserve “term structure” for zero-coupon (spot) rates, while “yield curve” can refer to yields on coupon-paying bonds.

Par, spot and forward curves. A par curve shows the coupon rates at which bonds of each maturity would trade at face value. The Treasury’s published curve is a par yield curve. A spot (zero-coupon) curve shows the yield for a single payment at each maturity. A forward curve shows implied future rates, as in the worked example above.

Yield curve vs. discount curve. A discount curve converts spot rates into discount factors, the present value of $1 received at each future date. It is the spot curve expressed in another form and is used to price cash flows.

Yield curve vs. price-yield curve. The price-yield curve describes a single bond. It plots that bond’s price against its yield and shows the inverse, convex relationship between the two. The yield curve compares many bonds across maturities.

Yield curve vs. yield curve control. Yield curve control is a policy in which a central bank targets the yield at a specific maturity and buys or sells bonds to hold it there. The Federal Reserve capped Treasury yields from 1942 to 1951, and the Bank of Japan targeted its 10-year yield from 2016 until 2024. Under such a policy, the targeted part of the curve reflects the central bank’s commitment rather than free-market expectations.

FAQs

The Bottom Line

The yield curve matters to bond investors, borrowers and anyone tracking the economic outlook, since lending rates, mortgage rates and corporate bond spreads key off Treasury yields. Read it by naming the two maturities being compared and watching the direction of change over time. Treat inversion as a warning with uncertain timing, because term premiums and central bank buying can distort the signal.