What This Module Covers
The yield curve is the single most important pricing reference for every ALM manager. It shows you the path of interest rates over time—what 2-year rates are, what 10-year rates are, what that spread (2s10s) tells you about the economy. This module teaches you to read curve shapes, anticipate curve movements, and translate curve signals into balance sheet implications.
Why This Matters to You
The yield curve determines:
- Your asset yields: Every mortgage, every commercial loan, every security you hold is priced off a point on the yield curve
- Your funding costs: Deposits and wholesale funding costs reflect expectations embedded in the curve
- Your net interest margin: The spread between what you earn on assets and what you pay on liabilities is fundamentally a curve trade
- Economic outlook: Yield curve inversions have preceded every US recession for decades. If you miss a curve inversion, you miss recession risk
- Duration decisions: Long rates don't move with short rates. Understanding the curve tells you when to take long duration (steep curve) vs. short duration (flat curve)
A flattening yield curve is one of the earliest signals of recession. Regional banks that didn't notice the 2s10s spread compress from +150bp to -50bp in 2022 didn't adequately prepare for 2023's challenges. Smart managers saw the curve flatten and began assuming lower rates sooner.
Key Concepts
The Yield Curve Defined
The yield curve shows the yield (interest rate) for Treasury securities across all maturities, from 3 months to 30 years, at a point in time. Plot these on a graph and you get a line—the curve.
Normally, the curve slopes upward: 3-month Treasuries yield 3%, 2-year Treasuries yield 4%, 10-year Treasuries yield 4.5%. This upward slope is the term premium—extra yield you get for lending long instead of rolling short.
When the curve inverts (2-year yields exceed 10-year yields), it's a recession signal. This has happened before each of the last 7 recessions.
The Curve Tells You Three Things Simultaneously
1. The level of rates: If the entire curve is at 4%, rates are "high" in absolute terms
2. The slope of the curve: If the 2s10s spread is +150bp, the curve is "steep"; if it's -50bp, it's "inverted"
3. Expectations about future rates: If the curve is steep and staying that way, markets expect rates to stay high for a while then fall; if it's flat, markets expect rates to stay roughly constant
What Different Curve Shapes Mean
- Normal (upward sloping): Curve yields 3%, 4%, 4.5%, 4.6% from 3mo to 10Y. This means short rates are low relative to long rates. Markets expect economic growth or modest inflation. This is the "healthy" curve.
- Flat: Curve yields 4%, 4%, 4.1%, 4.1%. This means the Fed has just finished tightening and the market doesn't see rate cuts coming immediately. Uncertainty is high.
- Inverted: 2-year yields 5%, 10-year yields 4%. The Fed has overtightened, or recession is priced in. This is a recession warning.
- Steep: 2-year yields 3%, 10-year yields 4.5%. Curve is steep because the Fed just cut and the market expects a recovery. This is typical early in an easing cycle.
The 2s10s Spread as Your Primary Signal
ALM managers obsess over the 2s10s spread (10-year Treasury yield minus 2-year Treasury yield). It's simple, easy to track, and incredibly predictive.
- +150bp or more: Very steep. Fed has just eased or is about to. Growth expectations are improving. This is when you want to take long duration.
- +50bp to +150bp: Normal steepness. Baseline case. This is the most common range.
- 0bp to +50bp: Flattening. The Fed is either about to stop hiking or has just stopped. Recession risk is rising. This is when you should start shortening duration and preparing for cuts.
- Negative (inverted): Recession is either happening or about to. This is the ultimate "reduce risk" signal for balance sheet management.
During 2022, the 2s10s went from +100bp (normal) to flat to inverted. Smart ALM managers caught this flattening and began repositioning. Banks that didn't notice and stayed long duration got caught in the 2023 duration crisis.
How the Curve Connects to Balance Sheet Decisions
Your balance sheet is a curve positioning decision.
When the curve is steep (normal conditions):
- Borrow short (deposits, short-term wholesale funding at low rates)
- Lend long (mortgages, 5-7 year commercial loans at high rates)
- Earn the steep part of the curve as your net interest margin
- This is the classic "3-6-3 banking"—pay 3% on deposits, lend at 6%, play golf at 3pm
When the curve flattens:
- The spread between what you earn (long) and pay (short) compresses
- If the curve inverts, you could be paying more on deposits than you earn on mortgages
- This is exactly what happened in 2023: Deposits cost 4%+, but new mortgage originations yielded only 6-7% (and old mortgages yielded 3-4%)
- The solution: reduce balance sheet size, reduce long duration assets, shift to variable-rate originations
When the curve is inverted (recession coming):
- This is the ultimate risk-off signal
- Asset quality deteriorates; loan losses rise; deposit pressure increases
- The time to shorten duration and reduce leverage is before the inversion, not after
Reading the Curve's Key Points
You don't need to know the entire curve. Focus on these five points:
1. 2-year rate: Anchored to Fed policy. Tells you where short rates are.
2. 5-year rate: Represents Fed policy expectations 2-3 years out. Tells you whether the market thinks the Fed is done.
3. 10-year rate: Long-term neutral rate + inflation expectations + term premium. Tells you the sustainable level of long rates.
6. 2s10s spread: The quintessential curve steepness measure.
7. 5s30s spread: Long-term duration expectations. If steep, markets expect long rates to stay low (recession scenario). If flat, markets expect long rates to rise (inflation scenario).
Practical Example: In June 2023, the Fed was still at 5.25% and signaling potential more hikes. But the 2-year Treasury was at 4.7% and the 10-year at 3.8%. The 2s10s spread was inverted at -90bp. What was the curve saying? "The Fed's rates are too high. Recession is coming. Cut rates fast." The market was right; the Fed cut in September 2023. An ALM manager reading the inverted curve would have begun preparing for cuts in mid-2023, not waiting for the Fed to announce them.
The Structure and Mechanics of the Yield Curve
How Rates Get Priced onto the Curve
Treasury securities form the baseline for all rate pricing in the banking system. When you buy a 10-year Treasury, you're buying a government promise to pay you a fixed coupon for 10 years, then your principal back.
The 10-year Treasury yield is determined by supply and demand in the open market. If expectations for inflation increase, bond prices fall and yields rise. If expectations for growth decline, bond prices rise and yields fall.
The Fed influences the curve at the short end (2-year and shorter) directly through setting the federal funds rate. The Fed influences the long end (7-year and longer) indirectly through forward guidance and through quantitative easing/tightening.
This is critical: The Fed controls short rates. The market prices long rates. If the Fed says "we're staying at 5.25% for a long time," it's guiding the 2-year rate. But if the market doubts the Fed will stay elevated (because it believes recession is coming), the 10-year rate can fall even as the 2-year rate stays high, inverting the curve.
During 2022-2023, this was exactly what happened. The Fed raised from 0% to 5.25% in about 18 months, supporting near-term rates. But long-term rates rose much less, and eventually fell, as markets priced in inevitable rate cuts from recession pressure.
The Term Premium and Why It Matters
The term premium is the extra yield you demand for lending long. It reflects three things:
1. Uncertainty: The further out you lend, the less certain you are about inflation and growth, so you demand more yield
2. Liquidity preference: You'd rather have cash now than later, so you demand extra to part with it
3. Risk: The longer the maturity, the more price risk you bear (duration risk), so you demand more yield
In 2022, when the Fed started hiking, the term premium was around +100bp. By 2023, it had compressed to around +30bp because:
- The Fed's actions had anchored inflation expectations
- Markets believed the Fed would eventually cut, reducing long-term rate uncertainty
- Liquidity improved (faster Fed hikes meant clearer pictures of the future)
Term premium compression is crucial to understand. Even as near-term rates stayed elevated, long rates fell because the term premium shrunk. A manager who loaded up on long-duration mortgages in 2022, assuming 4%+ rates forever, got hurt by term premium compression in 2023.
The Fed's Quantitative Easing and Tightening (QE/QT) and the Curve
When the Fed does QE (buys long-dated securities), it:
- Reduces the supply of long-duration bonds in the market
- Pushes investors to seek duration elsewhere
- Flattens the curve (long rates fall more than short rates)
When the Fed does QT (lets long-dated securities mature without replacing them):
- Increases the supply of long-duration bonds the private sector must hold
- Pushes long rates higher as the market absorbs this supply
- Can steepen or flatten the curve depending on what's happening to short rates
From 2022-2023, the Fed ran aggressive QT—its balance sheet fell from $9T to $7T. This added supply pressure to long-dated bonds, which should have steepened the curve. But other forces (recession expectations, term premium compression) overwhelmed QT effects, and the curve inverted anyway.
For ALM purposes, you need to track the Fed's balance sheet reduction plans in their summary of economic projections. If QT is accelerating, long rates have more supply pressure ahead.
Curve Shapes and What They Predict About Economic Growth
The Inverted Curve as a Recession Indicator
The inverted yield curve is the single most reliable recession indicator we have. Here's the historical track record:
- 1970: Curve inverted, recession followed
- 1980: Curve inverted, recessions followed
- 1990: Curve inverted, recession followed
- 2000: Curve inverted, 2001 recession followed
- 2006: Curve inverted, 2008 financial crisis followed
- 2019: Curve briefly inverted, followed by 2020 COVID recession
- 2022-2023: Curve inverted in mid-2022, and economists debated throughout 2023 whether recession would follow
The 2022-2023 inversion was notable because it inverted a year or more before economic weakness appeared. This is actually the historical norm. The inverted curve typically precedes recession by 12-24 months, not immediately.
Why does the curve predict recessions? Because when the Fed tightens enough to invert the curve, it's tightening past the "neutral" rate into overtightening. This eventually breaks growth and creates unemployment. Once growth weakens enough, the Fed starts cutting, and the curve steepens again.
The Steep Curve as a Growth Indicator
When the curve is very steep (2s10s spread of +150bp or more), it usually means:
- The Fed has just cut rates sharply, or is expected to
- Recession is being priced in but hasn't caused severe damage yet
- Once the recession passes, growth resumes, and the curve steepens initially (short rates stay low while long rates rise as growth expectations improve)
The April 2020 COVID crash is a clear example. The Fed cut to 0% in one week, the curve steepened massively (2s10s went to nearly +200bp), and then the economy recovered in 2021 as growth expectations improved.
For ALM purposes, a steep curve after the Fed has cut is a signal that the worst is behind you. This is when to start adding duration, taking longer-term mortgages, and assuming the deposit pressure is easing.
The Flat Curve as Transition Signal
A flat curve (2s10s around 0bp) usually means the Fed has stopped hiking and the market doesn't yet see clear recession coming. It's a "transition" state—stable but uncertain.
Flat curves typically don't last long. Either:
1. The economy proves more resilient than feared, growth picks up, long rates rise, curve steepens
2. Recession comes faster than expected, short rates fall, curve steepens
3. The Fed starts cutting, the curve steepens
Very rarely does a flat curve persist and then flatten further into inversion. Instead, flat curves are way stations on the journey from normal to inverted, or from inverted back to normal.
Curve Positioning Strategies for ALM Managers
Strategy 1: The Steep Curve Bet
When the curve is normal (2s10s +100bp to +150bp), you're earning the carry of the steep curve naturally. Deposits cost 3%, mortgages yield 5-6%, you earn 2-3% margin on that curve shape.
If you believe the curve will stay steep or steepen further, you can:
- Increase your loan-to-deposit ratio (higher leverage)
- Lock in long-term mortgages (take duration now before rates fall)
- Reduce hedging ratios (let your natural duration exposure run)
This is what most banks were doing in 2020-2021. The curve was steep (Fed at 0%, 10-year at 1.5%), deposits were cheap, mortgages were yielding well. The risk was that the Fed would tighten faster than expected (which it did in 2022).
Strategy 2: The Curve Flattening Hedge
When the curve begins to flatten (2s10s spread narrows from +100bp to +75bp to +50bp), you sense that the Fed's hiking cycle is nearing its end. You want to prepare for either a flat or inverted curve.
Hedges include:
- Reduce long-duration asset originations (mortgages become less attractive)
- Increase variable-rate originations (if rates fall, you benefit immediately)
- Reduce your loan-to-deposit ratio (size down to lower duration exposure)
- Add interest rate swaps to convert long-duration assets to shorter duration
This is what the best-practice banks did in mid-2022 when the 2s10s went from +50bp toward inversion. They anticipated the Fed would eventually stop, curve would flatten, and long rates would fall.
Strategy 3: The Inverted Curve Risk-Off
When the curve inverts (2-year yields exceed 10-year yields), you're in the "ultimate risk-off" regime. This is a recession signal, and economic damage is likely to follow.
ALM responses include:
- Dramatically reduce balance sheet size (shrink assets and liabilities together)
- Reduce variable-rate originations (if recession comes, rates fall faster than you can earn on variable-rate assets)
- Increase credit risk provisioning (loan losses will rise as economic activity contracts)
- Steepen your liability maturity structure (don't lock in low deposit costs; let them reprice as rates fall)
Banks that followed this playbook in 2022 avoided the 2023 crisis. Banks that didn't (like SVB) got caught with long duration, high origination rates, and insufficient capital.
Practical Curve Monitoring for the ALM Manager
Daily Ritual
Each morning before your ALM team starts work, check:
1. The 2-year rate: Where did it close yesterday? Is it up or down? This tells you whether Fed expectations changed.
2. The 10-year rate: Is it moving in line with the 2-year, or diverging? If diverging, the term premium is changing.
3. The 2s10s spread: Is it widening (steepening) or narrowing (flattening)? Compare to where it was a month ago and a year ago.
These three data points take 30 seconds to check and completely summarize the yield curve's current positioning.
Weekly Ritual
Once per week, pull back and ask:
- Is the curve in a trend toward steepening or flattening?
- Have any of the key points (2Y, 5Y, 10Y) broken a significant support or resistance level?
- Has Fed guidance changed in a way that affects your rate expectations?
- Is your loan origination pricing still appropriate for the current curve?
- Are your hedge ratios still calibrated for the current curve shape?
Monthly Ritual
Once per month in your ALM forum meeting, discuss:
1. Curve shape: Normal, flat, or inverted? What does that mean for the economy?
2. Term premium: Has it changed? If it's compressing, long rates will fall faster than short rates as the Fed cuts.
3. Origination decisions: Are we locking in rates appropriately given the current curve shape? If the curve is about to invert, we should reduce long-duration lending.
4. Hedge positioning: Given the current curve, are our hedge ratios appropriate? Flat or inverted curves call for different hedges than steep curves.
The 2022-2023 Case Study: From Steep to Inverted
In early 2022, the 2s10s spread was around +100bp (normal). The Fed was just beginning to hike. Over the course of 2022:
- Q1 2022: Curve remains roughly +100bp. Fed hikes are expected but gradual. Banks maintain normal leverage.
- Q2 2022: Curve begins flattening to +75bp as the Fed hikes 50bp (more than expected initially). Asset managers begin to shorten duration.
- Q3 2022: Curve flattens to +50bp as the Fed does a 75bp hike. Mortgage originators see volume decline as rates spike. Smart ALM managers begin asking: "When does the Fed stop?"
- Q4 2022: Curve approaches inversion (+25bp) as Fed does another 75bp hike and then signals it's nearing the end of hiking. Market is pricing in future cuts. Long rates fall even as short rates rise.
- Q1 2023: Curve inverts (-50bp) as the Fed holds at 4.75%-5.00% and market prices in 3-4 rate cuts by end-year. Regional banks begin to fail (SVB). The Fed lowers the discount window rate as a confidence measure.
- Q2-Q3 2023: Curve remains inverted but less so as deposits stabilize and rate cut expectations solidify. The Fed begins to clearly signal cuts are coming in September.
- Q4 2023 and beyond: Curve begins to steepen again as Fed cuts 25bp in September and another 25bp in December, and markets price in more cuts. The cycle turns.
Banks that had been tracking the 2s10s spread throughout 2022 could have seen the flattening coming and reduced their duration exposure. By Q1 2023, when the inversion was complete, it was too late for many regional banks. The lesson:
Watch the curve continuously. When it begins to flatten, assume it will invert and reduce your long-duration exposure. The curve is your north star; don't ignore its signals.