Because Treasurys are backed by the government, they’re considered among the safest investments in the world, with bonds and notes paying a fixed interest rate every six months until maturity.
Generally, bonds with longer durations give investors higher yields because of the uncertainty associated with putting away that money for years at a time, and the opportunity cost of tying up your money in a Treasury instead of, say, the stock market. (Obviously, investors want their dollars to earn enough to at least keep pace with the rate of inflation so they don’t lose purchasing power.)
People particularly pay attention to the two-year and 10-year Treasury yields, because they're proxies for short- and long-term economic sentiment.
Conners says the Treasury market is "always adjusting" to current conditions — including inflation, economic growth and geopolitical fears — "like a thermostat."
As a result, the yield curve generally takes one of three main shapes:
- Upward-sloping. This is its normal state, wherein bonds with shorter durations (like two-year Treasurys) have lower yields, and bonds with longer durations (like 10-year Treasurys) have higher yields.
- Flat. This is a transition state; it happens when short- and long-term interest rates are pretty much the same.
- Inverted. This occurs when long-term interest rates are below short-term interest rates. And it's a big deal.
"When the yield curve is normal, no one talks about it," Kenwell says. "When it's inverted, that's when everyone talks about it."
Inversions of the yield curve tend to coincide with periods of economic contraction. For instance, the yield curve inverted in August 1978 — and then a recession started in January 1980. A more recent example took place in January 2006: The yield curve inverted, and the Great Recession started 235 days later. (According to a 2023 analysis by Verdence Capital Advisors' Megan Horneman, there's usually about 15 months between an inversion and the official start of a recession.)
Why? Well, this is where it gets complicated. In a strong economy, longer-dated Treasurys have higher yields because investors expect interest rates to rise. But when Wall Street believes a recession is in the cards, the assumption is that interest rates will fall, since the Federal Reserve’s primary method to fight economic contraction is by lowering interest rates.
But while the yield curve is often a tipoff of a downturn, it's not always cause for alarm.
"When it inverts, it doesn't necessarily mean bad times are coming," Kenwell says. "When we are in a recession, the yield curve will almost always be inverted, but just because it inverts doesn't mean we're going to go into one."
Case in point: The yield curve inverted in both April 2022 and July 2022. We still haven't experienced a recession.
It's been uninverting lately, beginning this past August 2024. This has left sources like Planet Money wondering, "Can the yield curve still predict recessions?" and others, like Marketplace, interviewing sources who assert that "we’re on the edge of a slowdown."
Nobody knows what's going to happen, but Kenwell says it's not necessarily something I need to track closely if I'm simply investing for retirement via a 401(k). Because I've got decades before I need to touch my money, there's no real reason for me to worry about the yield curve and what it means for my portfolio. In fact, panicking and yanking my money out of the market at the wrong time could mean missing out on gains later on.
For more active investors, he recommends checking the yield curve weekly "because everyone's going to talk about it." And if I'm considering a major purchase or big financial decision — like, say, buying a house — it's not a bad idea to just peek at what it's doing. If it’s inverted, I might want to consider waiting until mortgage rates drop.
"I wouldn't let it dictate my decision in black and white," Kenwell says. "It's just one piece of [the] puzzle — any time you can have a little bit of a heads up when a big shift happens, it's nice."
