The yield curve is a graphical representation of different bond yields having the same quality but different maturities. A normal yield curve slopes upward, meaning that long-term yields are higher than the short-term ones and it generally signals economic growth. On the other hand, an inverted yield curve slopes downward with short-term yields being higher than the long-term ones and it never failed to predict a recession coming generally in the next 12 months.

When you see news talking about the yield curve steepening, it means that long-term yields are rising faster than the short-term ones, or the short-term yields are falling faster than the long-term ones. On the other hand, when you hear people talking about the yield curve flattening, that means that the short-term yields are rising faster than the long-term ones, or the long-term yields are falling faster than the short-term ones.

The most common yield curve used as benchmark to gauge the shape of the curve is the yield spread between the US 2 Year Note and the US 10 Year Note (see the picture above). You can chart it yourself going to tradingview.com and searching for “US10Y-US02Y”. You will notice that when the yield spread crossed the 0% level, a recession followed 12 months or so thereafter. Another thing you will notice is that a tightening monetary policy by the Fed flattens the yield curve.

This just shows you how important the monetary policy is. Generally, an expansionary policy is a yield curve steepener because low rates favour business investment and consumer spending, while a contractionary one is a curve flattener because businesses at a certain point hold on from borrowing at higher rates and consumers prefer to save.

Although the yield curve is the best leading indicator that financial markets have at disposal, remember that the market is forward-looking, and you shouldn’t just watch the curve and trade accordingly. Your job is to anticipate the changing in economic pictures and position before something happens. Never invest in the present.

This article was written by Giuseppe Dellamotta.