How the Yield Curve Indicates Market Expectations

What is the yield curve saying - here's an interpretation based on the common known theories that apply to yield curve shaping - ****Part 2****: Market Segmentation Theory ("Different Playgrounds"): What it suggests today: Short-End Playground: Rates here (e.g., 3-month to 2-year) are heavily dictated by the Federal Reserve's current policy (which has rates relatively high after a period of fighting inflation) and the demand from entities like money market funds that need short-term, safe places for cash. Long-End Playground: Rates here (e.g., 10-year, 30-year) are influenced by big players like pension funds, insurance companies, and foreign governments. Their demand is being met by a large supply of U.S. government debt. Concerns about the size of government borrowing and long-term inflation can make these buyers demand higher yields in their "playground." Preferred Habitat Theory ("Comfort Zone, but Will Move for Money"): What it suggests today: Investors might prefer certain maturities, but current conditions could be influencing their willingness to move. With the Fed on hold but potential for future cuts, some investors might be hesitant to go too far out on the long end unless yields are attractive enough to lure them from their shorter-term "comfort zones." The need for the Treasury to finance government operations means it's issuing bonds across maturities. To ensure all these bonds are bought, yields might adjust to entice investors to step out of their preferred habitat if there's an imbalance in supply and demand in a particular segment. The current upward slope suggests investors are requiring that extra compensation to move into longer maturities, likely due to a combination of inflation expectations and the risk premium for longer duration, plus the sheer volume of bonds being issued. In a Nutshell for Today (May 24, 2025): The Treasury yield curve is saying that: Investors think interest rates will stay reasonably firm for a while, though perhaps not skyrocket, and they're not betting on immediate, deep cuts by the Fed across the board. Lending money to the government for a long time is seen as requiring extra compensation right now, partly due to lingering inflation worries and the amount of debt the government is issuing. Different types of investors are playing in their usual maturity areas, but the overall picture is one where you get paid more for the uncertainty and reduced flexibility of holding longer-term government debt. It's a cautious but not panicked market view.

In the last several weeks, interest rates on U.S. Treasury yields have increased markedly. Interestingly, the increase in rates has been most prevalent on the "long end" of the yield curve, that is, Treasuries that don't mature for many years. This has perplexed some, but I think there's a relatively straightforward interpretation of the rise in long-dated Treasury rates: people are expecting interest rates to stay higher for longer.   At a very high level, the Treasury Yield curve (which shows interest rates for Treasuries with different maturities) is a current snapshot of the market's interest rate expectations. Typically, longer-dated Treasuries have higher yields than shorter dated ones, since investors want to be compensated for the increased risk of a long-dated bond with a higher return. When the yield curve inverts, short term interest rates move higher than long term ones.   Yield curve inversions almost don't make sense - why would anyone accept a lower return for a longer-dated, and therefore higher risk, bond? The explanation has to do with reinvestment risk, which is the risk that you won't be able to get the same interest rate you can today when your short term Treasury comes due. As an example, imagine you're deciding between a 2-Year treasury and a 10-Year treasury. Currently, 2-Years have higher rates. If you go with the 2-Year, and interest rates are meaningfully lower when you need to reinvest that money in two years, your total return may well be lower than if you just purchase the 10-Year and held it.   Inverted yield curves are, therefore, often an indication that the market expects short term rates to fall in the intermediate-run future. But what if there were no catalyst for the Federal Reserve to lower short term rates? What if, instead, the labor market remained stronger than anticipated and inflation simultaneously remained above the Fed's target despite a higher rate environment? Then expectations about short term rate decreases would become less certain while expectations for higher rates for longer become more likely.   The yield curve has been inverted for some time now, and it can only become "uninverted" in one of two ways: 1) short term rates fall or 2) long term rates rise. Throughout 2023, both short term and long term rates rose (see chart below). Each quarter that passes without a recession or labor market softness arguably decreases the chance of a rate cut in the near future.   (See comments for another fun chart)