Yield Curve: Shapes and Recession Warning Signals

The yield curve plots Treasury yields across maturities. Its shape is one of the most reliable recession predictors available — every US recession since 1955 was preceded by an inversion, typically 12–18 months ahead.

The four shapes

Normal (upward sloping): long yields higher than short. The default state; compensates investors for duration risk. Growth and risk assets typically perform well.
Steep: long yields far above short. Occurs early in recoveries or when inflation expectations rise. Bullish for banks (borrow short, lend long) and cyclicals.
Flat: long and short yields converge. The transition state; signals late-cycle. The curve flattening is the early warning, before inversion.
Inverted: short yields above long. The recession siren. Markets price rate cuts ahead because growth is deteriorating.

The two spreads that matter

2s10s (10-year minus 2-year): the most-watched by media. Inversion here is the classic signal, but it can invert and uninvert, creating noise.
3m10y (10-year minus 3-month): the Fed's preferred measure, and historically the more reliable recession predictor. When this inverts, recession probability within 12 months rises sharply.

Track both. A 2s10s inversion without a 3m10y inversion is a weaker signal than both inverting together.

How to trade it

Do not short the moment of inversion. The lead time is 12–18 months, and equities often rally for months after inversion before peaking. Trading the inversion as an immediate sell signal is a known way to be early and wrong.
Rotate, don't exit. As the curve flattens and inverts, shift from cyclicals and small caps toward defensives (utilities, staples, healthcare) and quality (low-debt, stable-earnings large caps). These outperform in late cycle.
Steepening trade (post-recession): when the curve is deeply inverted and the Fed begins cutting, go long banks and cyclicals — the re-steepening as front yields fall is the recovery signal.
Bond positioning: curve inversion favors duration (own the long end, which will rally as the Fed cuts). Steepening favors the front end.

Caveats

Inversion is necessary but not sufficient — a shallow inversion that quickly re-steepens may not produce recession. Depth and duration matter; sustained inversion below -30bp on 3m10y is the stronger signal.
Quantitative easing distorts the curve by suppressing long-end yields. Adjust interpretation when the central bank is actively buying bonds — the signal is muddied but not invalidated.

The yield curve is a regime indicator, not a timing tool. Use it to set portfolio tilt across a 6–18 month horizon, not to time the next 30 days.