What the yield curve knows: expectations, term premia, and inversion as recession signal.
Warming up the engine…
The pattern of interest rates across maturities, explained by expected future short rates (expectations hypothesis) plus term premia for bearing duration risk.
Long rate ≈ average of expected short rates + term premium
An upward slope is normal (compensation for time); an INVERTED curve says markets expect rate cuts, historically the single best recession predictor. Central banks read the curve as the market's forecast of their own future policy.
Name all three theories, expectations, liquidity premium, segmented markets, and use inversion as your applied example.
Now prove you have it
Move the curve to where you think it lands, and get told exactly which part you got right.
Real-world scenarios on this model
Equilibrium at T 1, i 2.5.
Equilibrium: T* = 1.0, i* = 2.5
Current equations
One borrower, many horizons. The curve shows the interest rate on safe bonds at each maturity, anchored at the short end by the central bank. It usually slopes up: lock money away longer, earn more. When it flips downward, recession chatter starts.