The yield curve plots the yield on government bonds of different maturities against time to maturity at a single point in time. It is the most important chart in fixed income, and arguably in finance generally, because it summarises the market's view of the path of short-term rates, inflation, and risk premium across every horizon at once.
Constructing a curve
In practice, market participants build curves by bootstrapping from observable Treasury yields. The 3-month, 6-month, 1-year, 2-year, 5-year, 10-year, and 30-year on-the-run Treasury yields anchor the curve; intermediate points are interpolated. For Kenya, CBK's weekly T-bill auctions (91-day, 182-day, 364-day) plus the bond auctions across 2-, 5-, 10-, 15-, 20-, and 25-year tenors provide the same set of anchor points.
Three shapes
- Normal (upward-sloping): long yields above short yields. The historical default — investors demand a term premium for lending longer.
- Flat: long and short yields roughly equal. A transitional state typically seen near cycle peaks.
- Inverted: long yields below short yields. Historically rare and historically predictive of recession.
Three theories of the curve's shape
Pure expectations theory says long yields are simply the geometric average of expected future short rates. If the market expects the Fed to hold rates flat, long and short yields should be equal; if cuts are expected, long yields should be below current short yields. Liquidity-preference theory adds a term premium for the extra risk and inconvenience of lending longer, biasing the curve upward even when expectations are flat. Market-segmentation theory argues that buyers of short-dated paper (money-market funds) and buyers of long-dated paper (pension funds) operate in distinct markets, so curve shape reflects supply and demand within each segment.
Why both expectations and term premium matter
When yields move, decomposing the move into 'expected-short-rate path changed' versus 'term premium changed' is one of the deepest analytical exercises in macro. The New York Fed publishes both decompositions (ACM model). After the 2022 hikes, the spike in 10-year yields was substantially term premium — investors demanded more compensation to lend long in an uncertain inflation environment.
Why inversions matter
The 10-year minus 3-month spread (or 10-year minus 2-year, depending on convention) has inverted before every US recession since 1955 with only one false signal (the late-1960s episode). The intuition: investors expect short rates to fall meaningfully in the future, which happens almost always because the central bank is responding to a recession. The lag from inversion to recession ranges from 6 months to nearly 2 years, but the signal itself is unusually reliable for a single financial indicator.
The 2022-24 inversion episode
The US yield curve inverted in mid-2022 and remained inverted for over two years — the longest inversion in modern history. The recession that 'should' have arrived in 2023 or 2024 did not. Debate over whether the signal has 'broken' or whether the recession is merely delayed has dominated the macro discourse since. The honest answer: the signal still works, but the lag is longer than past cycles because of post-COVID fiscal support, near-record employment, and the unique post-pandemic interest-rate path.
Reading the Kenyan curve
The Kenyan curve typically shows 91-day yields anchored around the CBK Repo Rate plus a small term premium, with 10-year yields trading 200-400 bps above that. Wide curves indicate fiscal stress; flat curves indicate either tight CBK policy or weak demand for duration. Track the 91-day yield and the 10-year yield each Tuesday after the weekly auction.
Exercise
The US 10-year Treasury yield is 4.20%, the 3-month is 5.30%. Is the curve normal, flat, or inverted? What does this typically signal?