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When the US government wants to borrow money, the Treasury issues debt. This debt may take the form of a Treasury Bill, Note, or Bond depending on its term to maturity, i.e. the length of time the government is asking to borrow money for, and collectively these kind of debt instruments are called Treasuries.

When purchasing Treasuries, one has to keep track of the par value, the coupon rate, and the price. The par value is the underlying value of the bond, i.e. what the government owes you. If you buy a ten year Treasury Note with a \$1,000 par value, then at the end of those ten years the government will pay you back \$1,000. The coupon rate is what we might commonly call the interest rate. Every year you hold the bond, the government will pay you an additional sum equal to the coupon rate times the par value. So continuing the previous example, if you buy a ten year Treasury Note with a \$1,000 par value and a five percent annual coupon, then once every year (until the bond matures) the government will pay you \$50 for lending them your money.

However, when most Treasuries are purchased, whether through direct auctions by the government or a secondary market, the price paid by the buyer is rarely equal to the par value. Instead, Treasuries are bought and sold at at a discount or premium on the par value. For instance, if the stock market is slumping and investors are searching for someplace safe to keep their money, they may turn to Treasuries, thereby driving up demand and increasing the price above par. For example, You might be willing to pay \$1,100 for a \$1,000 par value bond based on the security it gives you, i.e. you are paying a \$100 premium. This is where the concept of yield comes in. The yield is simply the annual coupon payment divided by the market price of the bond. So if you purchased a ten year Treasury Note with a \$1,000 par value and a five percent annual coupon for \$1,100, then your yield would be $\frac{0.05 \times 1000}{1100} = 0.0455$; in other words, the yield would be 4.55%.

The yield curve simply comes from plotting the bond yields of Treasuries at each maturity term length. Typically, the yield curve is upward sloping, indicating that the longer you are willing to lend out your money, i.e. the more interest rate risk you are willing to take on, the more you will be paid.¹ In rare cases, short-term yields can actually rise above long-term yields, in which case the curve is said to be inverted. Campbell Harvey’s 1986 dissertation linked inversions of the curve to near-term economic downturns, and in the intervening years the inverted yield curve has demonstrated remarkable accuracy for predicting recessions.

The ten-year/two-year Treasury spread is one of the most reliable leading indicators of recession within the following year. For as long as the Fed has published this data back to 1976, it has accurately predicted every declared recession in the U.S., and not given a single false positive signal.²

Even the current 2020 COVID-19 recession was preceded by a yield curve inversion in August 2019 (most will point to this as a technicality, but it’s a perfect record nonetheless). Here’s the link for direct access to the Shiny app. The source code is also available on my GitHub.

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