The Yield Curve and Inflation Expectations: From Theory to Trade in a Post-Pandemic World

Section 1: The Architecture of the Yield Curve

To decipher the messages embedded in the bond market, one must first understand its fundamental architecture. The yield curve is more than a simple line on a chart; it is a visual representation of the market’s collective forecast for the future, built upon a foundation of economic theory that links interest rates across different time horizons.

1.1 The Term Structure of Interest Rates: A Visual Representation of Market Expectations

The term structure of interest rates is the relationship between the yields on bonds of equal credit quality but different maturities. When this relationship is plotted graphically, it is known as the yield curve. For the purposes of macroeconomic analysis, the benchmark is invariably the sovereign yield curve of a major economy, such as the one for U.S. Treasury securities, which plots yields for maturities ranging from one month to 30 years. These securities are considered to be free of credit risk, meaning that any variation in their yields is driven by expectations about time and macroeconomic factors, not the likelihood of default.

The significance of the yield curve extends far beyond the government bond market. It serves as a foundational benchmark for pricing a vast universe of other debt instruments. Rates on everything from corporate bonds and bank loans to residential mortgages are typically priced as a spread over the corresponding Treasury yield. Therefore, the level and shape of the yield curve directly influence the cost of capital for businesses and households, making it a central component in the transmission of monetary policy and a key determinant of economic activity. Most importantly, the curve reflects the market’s continuous assessment of future economic conditions, including growth, inflation, and the anticipated path of central bank policy.

1.2 Yield Curve Shapes and Their Economic Signals

The shape of the yield curve is not static; it changes in response to new information and shifting expectations. Analysts have identified four primary shapes, each carrying a distinct message about the state of the economy.

• Normal (Upward Sloping) Curve: This is the most common and intuitive shape, where long-term bonds have higher yields than short-term bonds. The upward slope reflects two main factors. First, investors typically demand a higher rate of return, a term premium, to compensate them for the increased risks associated with tying up their capital for longer periods. These risks include unexpected changes in interest rates and inflation that could erode the value of their investment. Second, a normal curve signals that the market expects stable economic expansion. In a growing economy, demand for capital is robust, and the central bank may be expected to gradually raise policy rates in the future, justifying higher yields on long-term debt.
• Steep Curve: A steep yield curve is an exaggerated version of the normal curve, where the spread between long-term and short-term yields is particularly wide. This shape often emerges at the beginning of an economic recovery. Central banks typically hold short-term policy rates low to stimulate growth, while investors, anticipating a rebound in activity and a potential rise in future inflation, demand a much higher yield to hold long-term bonds. A steep curve is therefore a strong signal of expected future economic growth and, critically for this report, rising inflationary pressures.
• Inverted (Downward Sloping) Curve: An inverted yield curve, where short-term yields are higher than long-term yields, is a relatively rare but powerful phenomenon. It is widely regarded as one of the most reliable leading indicators of an economic recession. The logic is straightforward: an inverted curve implies that investors expect economic conditions to deteriorate to such an extent that the central bank will be forced to cut its policy rate significantly in the future. This expectation of lower future short-term rates drives down the yield on long-term bonds today, causing them to be lower than current short-term rates. The inversion of the U.S. 10-year/2-year Treasury spread, for example, has preceded every recession for the past 50 years, with only one false positive.
• Flat Curve: A flat yield curve, where there is little difference between short-term and long-term yields, typically signals a period of economic uncertainty and transition. It often occurs as a normal curve flattens on its way to a potential inversion, suggesting the market is divided on the economic outlook. It can indicate that the central bank is nearing the end of a tightening cycle, with investors anticipating that further rate hikes could slow the economy.

The dynamic evolution of the curve’s shape provides a continuous narrative of the market’s shifting economic outlook. A flattening of a normal curve suggests that expectations for future growth are moderating, while a steepening suggests they are strengthening. It is this dynamic nature, rather than a single static snapshot, that offers the most valuable information for analysts and investors.

1.3 The Expectations Hypothesis: The Theoretical Bedrock

The ability to interpret the yield curve’s shape as a forecast of future economic conditions rests on a cornerstone of financial economics: the expectations hypothesis of the term structure of interest rates. In its purest form, the theory posits that the yield on a long-term bond is simply the geometric average of the current one-period short-term interest rate and the series of one-period short-term rates expected to prevail over the life of the long-term bond.

The underlying principle is one of no-arbitrage. An investor with a two-year investment horizon has two primary choices: buy a two-year bond and hold it to maturity, or buy a one-year bond today and, upon its maturity, reinvest the proceeds in a new one-year bond. For the market to be in equilibrium, the expected return from both strategies must be equal. If the expected return from rolling over short-term bonds were higher, investors would sell the two-year bond and buy the one-year bond, driving the price of the former down (and its yield up) until the expected returns are equalised.

This relationship can be expressed more formally through a linearised equation. For an n-period bond, its yield, Rt(n)​, can be approximated as the average of the current one-period rate, rt(1)​, and the expected future one-period rates, plus a constant term premium, θn​:

Rt(n)​≈n1​i=0∑n−1​Et​[rt+i(1)​]+θn​ where Et​ denotes the expectation based on information available at time t.

The “pure” expectations hypothesis assumes the term premium, θn​, is zero. While this strong form is often rejected in empirical studies, as investors do, in fact, demand compensation for interest rate risk, and this premium can vary over time, the core insight of the theory remains powerful. It establishes the crucial link that allows analysts to interpret the yield on a 10-year bond not merely as a passive rate of return, but as an active market forecast of the average path of central bank policy rates over the next decade. An inverted yield curve, therefore, is not just a statistical curiosity; it is a direct market signal that investors are pricing in a high probability of future monetary policy easing in response to an anticipated economic downturn. This theoretical underpinning transforms the yield curve from a collection of bond prices into a vital, forward-looking economic indicator.

Section 2: Breakeven Inflation – The Market’s Price on Future Prices

While the shape of the nominal yield curve provides broad signals about future growth and policy, the bond market offers a more direct tool for gauging inflation expectations. The advent of inflation-protected government securities has allowed analysts to decompose nominal yields into their constituent parts, real rates and inflation expectations, providing a high-frequency, market-based measure of where investors believe prices are headed.

2.1 Anatomy of Inflation-Protected Bonds: TIPS and Index-Linked Gilts

Inflation-protected bonds, known as Treasury Inflation-Protected Securities (TIPS) in the United States and Index-Linked Gilts (ILGs) in the United Kingdom, are designed to shield investors from the erosive effects of inflation. Unlike a conventional nominal bond, which pays a fixed coupon and principal, the principal value of an inflation-protected bond is adjusted to reflect changes in a specified inflation index, the Consumer Price Index (CPI) in the U.S. and, historically, the Retail Prices Index (RPI) in the UK.

The mechanism works as follows: if inflation rises by, for example, 3% over a year, the $1,000 principal of a TIPS would be adjusted upward to $1,030. The bond’s coupon payments, which are a fixed percentage of the principal, are then calculated based on this new, higher principal amount. At maturity, the investor receives the inflation-adjusted principal. This structure ensures that the bond’s yield represents a real rate of return, a return guaranteed over and above the rate of inflation. In contrast, the holder of a nominal bond sees the purchasing power of their fixed payments diminish as inflation rises. The UK has a particularly deep and long-standing market for this type of debt, with index-linked gilts comprising nearly a quarter of the government’s wholesale debt portfolio at the end of 2024.

2.2 Calculating and Interpreting Breakeven Inflation Rates

The existence of both nominal and inflation-protected bonds of the same maturity allows for the direct calculation of the market’s implied inflation forecast. This metric is known as the breakeven inflation rate. It is calculated simply as the difference between the yield on a nominal bond and the real yield on an inflation-protected bond of the same maturity: Breakeven Inflation Rate=Nominal Yield−Real Yield (TIPS/ILG Yield).

The breakeven inflation rate represents the average rate of inflation over the bond’s lifetime at which an investor would be economically indifferent between holding the nominal bond or the inflation-protected one. For instance, if the 10-year nominal Treasury yields 4% and the 10-year TIPS yields 2%, the 10-year breakeven inflation rate is 2%. This means the market is pricing in an average inflation rate of 2% over the next decade. If an investor believes actual inflation will average more than 2%, they would prefer to own the TIPS, as its inflation protection would make it the higher-returning asset. Conversely, if they expect inflation to average less than 2%, they would prefer the nominal Treasury.

Because breakeven rates are derived from actively traded securities, they provide a continuous, high-frequency signal of the market’s collective inflation outlook, making them an invaluable tool for central banks and investors seeking to gauge sentiment in real time.

2.3 Current Market Snapshot (June 2025)

Applying this framework to the market data from mid-June 2025 provides a timely assessment of where inflation expectations currently stand. The data reveals a market that, while not pricing in a runaway inflation scenario, remains skeptical that central banks can return inflation sustainably to their 2% targets in the medium term.

In the United States, data from the Federal Reserve’s H.15 statistical release as of June 12, 2025, shows the following:

• The 10-year nominal Treasury yield stood at 4.36%.
• The 10-year TIPS real yield was 2.11%.
• This implies a 10-year breakeven inflation rate of 2.25% (4.36% – 2.11%), a figure confirmed by Federal Reserve Bank of St. Louis data.
• The 5-year nominal Treasury yield was 3.97%.
• The 5-year TIPS real yield was 1.69%.
• This implies a 5-year breakeven inflation rate of 2.28% (3.97% – 1.69%), also consistent with other sources.

In the United Kingdom, obtaining precise real yields is more complex due to the structure of the index-linked gilt market, which is linked to the RPI, a measure that typically runs higher than the official CPI inflation target. However, market data as of June 12, 2025, shows a 10-year nominal gilt yield of 4.50% and a 5-year nominal gilt yield of 4.06%. While direct real yields are not provided in the source material, market commentary from early 2025 suggests that UK breakeven rates for CPI were running around 2.8%, indicating that, similar to the U.S., market-based inflation expectations are above the Bank of England’s 2% target.

The table below summarises the key data for the U.S. market, highlighting the divergence between market-priced inflation and official central bank targets.

Data as of June 12, 2025. 

The data clearly shows that for both the five- and ten-year horizons, the market is pricing in average inflation of 25-30 basis points above the Federal Reserve’s 2% goal. This suggests a persistent belief among investors that either the Fed will tolerate a modest overshoot or that structural forces will make achieving the 2% target more difficult than in the pre-pandemic era.

Furthermore, the term structure of these breakeven rates offers a more nuanced forecast. In the U.S., the 5-year breakeven rate (2.28%) is slightly higher than the 10-year breakeven rate (2.25%). This “inversion” in the breakeven curve implies that the market expects inflation to be higher over the next five years than in the five years that follow. Specifically, it suggests the market is pricing in a 5-year, 5-year forward inflation rate, the market’s expectation for average inflation between 2030 and 2035, that is below 2.25%. This is a crucial signal: despite near-term anxieties about price pressures, the bond market is still pricing in a degree of long-term credibility for the Federal Reserve, expecting that monetary policy will eventually guide inflation back toward its target.

Section 3: Beyond the Headline – Deconstructing Breakeven Rates for a Truer Signal

While the breakeven inflation rate is an indispensable tool, treating it as a pure, unadulterated measure of inflation expectations is a common but significant analytical error. The yield spread between nominal and inflation-protected bonds is affected by at least two other time-varying factors: an inflation risk premium and a liquidity premium. For a sophisticated understanding, one must deconstruct the breakeven rate to account for these distorting influences.

3.1 The Inflation Risk Premium (IRP)

The inflation risk premium (IRP) is the additional compensation that investors demand for holding a nominal bond to protect against the risk that future inflation may be higher or more volatile than currently expected. It is a payment for bearing uncertainty. Since TIPS and ILGs offer a built-in hedge against this uncertainty, their yields do not contain an IRP. In contrast, nominal bond yields do.

This has a direct effect on the calculation of breakeven inflation. A positive IRP increases the yield on nominal bonds, thereby widening the spread over real yields. Consequently, a positive IRP causes the raw breakeven inflation rate to overestimate the market’s true mean expectation for inflation. For example, if the true expected inflation is 2.0% and the IRP is 0.5%, the breakeven rate would appear as 2.5% (ignoring other factors).

Quantifying the IRP is a significant challenge, as it is not directly observable. Academic research has produced a wide array of estimates, with little consensus on its precise magnitude. Studies have found the 10-year IRP to be anywhere from negative during periods of deflationary fear to over 100 basis points during periods of high inflation uncertainty. The key takeaway for analysts is that the IRP is not constant; it is a dynamic component that likely rises when inflation becomes more volatile and central bank credibility is questioned, as was the case in the 1970s and has been a concern in the post-2021 environment.

3.2 The Liquidity Premium

The second major distorting factor is the liquidity premium. The market for conventional nominal government bonds, particularly U.S. Treasuries, is the deepest and most liquid financial market in the world. The market for their inflation-protected counterparts, while substantial, is comparatively smaller and less liquid. This means it can be slightly more difficult or costly to trade TIPS in large volumes without affecting the price.

To compensate for this lower liquidity, investors demand a higher yield on TIPS and ILGs than they would on an otherwise identical but more liquid security. This liquidity premium embedded in TIPS yields pushes them higher, which in turn narrows the spread against nominal yields. The result is that the liquidity premium causes the raw breakeven inflation rate to underestimate true inflation expectations.

Like the IRP, the liquidity premium is not static. Research has shown it to be highly time-varying and countercyclical. During periods of acute financial stress, such as the 2008 Global Financial Crisis, investors engage in a “flight to quality and liquidity,” selling off less-liquid assets and piling into the most liquid instruments available, on-the-run nominal Treasuries. This causes the liquidity premium on TIPS to spike dramatically. Indeed, during the worst of the 2008 crisis, the 5-year breakeven rate plunged to a low of -2.24%, a level that suggested severe deflation was imminent. This was not a true reflection of expectations but rather a signal of extreme market dislocation driven by a massive liquidity premium. More recent academic work using advanced term structure models estimates the average liquidity premium on 10-year TIPS to be around 34 basis points, though it can fluctuate significantly.

3.3 Synthesising the Premia: A Corrected View of Inflation Expectations

To arrive at a more accurate measure of the market’s inflation forecast, one must adjust the raw breakeven rate for both premia. The full decomposition is as follows:

{Breakeven Inflation} = {Expected Inflation} + {Inflation Risk Premium} – {Liquidity Premium}.

The two premia work in opposite directions, and in stable market conditions, they may partially cancel each other out. However, their relative importance shifts with the economic regime. In an environment like that of 2025, characterised by heightened uncertainty about the persistence of inflation, the IRP is likely positive and elevated. At the same time, as central banks unwind their balance sheets through quantitative tightening (QT), overall market liquidity may be reduced, potentially keeping the TIPS liquidity premium from disappearing entirely.

The net effect of these two forces on the breakeven rate is ambiguous without a formal model, but the analytical framework itself is invaluable. It forces the sophisticated analyst to move beyond a naive reading of the breakeven rate. The crucial lesson, underscored by the 2008 experience, is that raw breakeven inflation rates are at their least reliable as a pure measure of expectations precisely during periods of high economic and financial stress, the very moments when a clear signal is most needed. An analyst who interpreted the deeply negative breakeven rates of late 2008 as a forecast of sustained deflation would have been misled by technical market factors, as survey-based measures of expectations remained positive. This historical precedent validates the necessity of a premium-adjusted approach to interpreting the signals from the bond market today.

Section 4: A Historical Tale of Two Curves – The 1970s vs. The 2010s

The relationship between the yield curve and inflation is not a static, universal law; it is a function of the prevailing macroeconomic regime and, most importantly, the credibility of the monetary authority. A historical comparison between the “Great Inflation” of the 1970s and the “Lowflation” era of the 2010s provides a stark illustration of how differently the bond market behaves when inflation expectations are unanchored versus when they are firmly anchored.

4.1 The Great Inflation (1970s): Unanchored Expectations and Policy Missteps

The 1970s were a defining period of macroeconomic turmoil for the developed world, characterised by the toxic combination of high unemployment and soaring, volatile inflation, a phenomenon dubbed “stagflation”. In the United States, annual CPI inflation, which was below 6% in 1970, surged to over 11% in 1974 and peaked at 13.5% in 1980. The United Kingdom experienced an even more severe bout of inflation, with the annual rate climbing from 6.4% in 1970 to a staggering 24.2% in 1975.

This inflationary environment was reflected in government bond yields. In both the U.S. and UK, nominal yields climbed into the double digits. The U.S. 10-year Treasury yield, for instance, rose from around 6% in the early 1970s to over 15% during the “Volcker shock” of the early 1980s. The yield curve was exceptionally volatile during this period, frequently inverting as the market reacted to successive inflationary waves and the Federal Reserve’s belated and aggressive policy responses.

The fundamental cause of this instability was the un-anchoring of inflation expectations. Policymakers, operating under the assumption of a stable Phillips curve, believed they could tolerate slightly higher inflation in exchange for lower unemployment. This policy mistake, compounded by external supply shocks like the oil crises of 1973 and 1979, allowed inflation expectations to drift upward. As the public and markets lost faith in the central bank’s commitment to price stability, a vicious cycle ensued: workers demanded higher wages to compensate for expected inflation, and firms raised prices in anticipation of higher costs, making inflation a self-fulfilling prophecy.

4.2 The Era of Lowflation (2010s): Anchored Expectations and the Zero Lower Bound

The decade following the 2008 Global Financial Crisis presented a mirror image of the 1970s. The predominant concern for central banks was not high inflation, but rather “lowflation”, a persistent tendency for inflation to run below the official 2% target. From 2010 to 2019, annual CPI inflation in the U.S. averaged just 1.8%. In the UK, the average was similar, at around 2.0%.

This environment of low and stable inflation was a direct result of the hard-won credibility of central banks following the Volcker disinflation. With inflation expectations firmly anchored at the 2% target, the economic dynamics changed profoundly. The Phillips curve relationship appeared to flatten, meaning that even as unemployment fell to multi-decade lows, it did not trigger an acceleration in inflation as it had in the past.

The yield curve reflected this new regime. Nominal yields across the curve fell to historic lows, with central bank policy rates pinned near the zero lower bound (ZLB) for much of the decade. The yield curve was persistently flat, with a much smaller spread between long and short rates compared to previous eras. This flatness was a direct consequence of anchored long-term inflation expectations and the market’s belief that policy rates would remain “lower for longer”.

The following table provides a quantitative comparison of these two distinct eras, illustrating the dramatic shift in both inflation and the yield curve’s structure.

U.S. Inflation; UK Inflation; U.S. Yields; UK Yields. Yields are annual averages.

This stark contrast reveals a crucial distinction. In the 1970s, yield curve movements were dominated by shifting inflation expectations and the associated inflation risk premium. Any sign of economic strength was immediately priced as a harbinger of higher inflation, causing long-term nominal yields to spike. 

In the 2010s, with inflation expectations firmly anchored by credible central banks, the pass-through from economic activity to inflation fears was muted. Yield curve movements were instead driven primarily by shifts in expectations for real economic growth and changes in the real term premium. This regime shift is fundamental to interpreting the yield curve in 2025. The key question for analysts is whether the recent inflationary episode has permanently damaged central bank credibility, pushing the market back toward a 1970s-style dynamic, or whether the anchoring of the 2010s will ultimately reassert itself.

Section 5: Actionable Insights and Investment Strategies

A thorough understanding of the yield curve and its relationship with inflation is not merely an academic pursuit; it forms the basis for concrete, actionable investment strategies. By translating the signals from the bond market into portfolio decisions, investors can better navigate changing economic cycles, manage risk, and protect the real value of their capital.

5.1 Fixed-Income Portfolio Strategy: Riding the Curve and Hedging Inflation

For fixed-income investors, the yield curve is the primary compass. Its shape and the breakeven rates derived from it provide direct guidance for two of the most critical portfolio decisions: duration management and the choice between nominal and inflation-protected securities.

Duration Management: Duration measures a bond’s price sensitivity to changes in interest rates. Active portfolio management involves adjusting duration based on forecasts for the yield curve’s movement.

• When the Curve Steepens: A steepening yield curve, which signals expectations of stronger growth and higher inflation, typically involves rising long-term interest rates. To mitigate the price losses on long-term bonds that this would cause, a prudent strategy is to shorten the portfolio’s duration. This reduces exposure to the most volatile part of the curve.
• When the Curve Flattens or Inverts: A flattening or inverting curve signals an economic slowdown and expectations of future central bank rate cuts. In this scenario, investors often seek to lengthen their portfolio’s duration. By owning long-term bonds, they stand to benefit from price appreciation as long-term yields fall in anticipation of and during an easing cycle. This strategy is often referred to as “riding the curve,” as investors profit from both the higher initial yield and the subsequent price gains as the bond “rolls down” a steepening curve in the aftermath of a recession.

The Breakeven Decision: The choice between nominal bonds and their inflation-protected counterparts is a direct trade on future inflation relative to the market’s current pricing. The breakeven inflation rate is the decision’s fulcrum.

• The Basic Strategy: If an investor’s independent forecast for average inflation over a given horizon is higher than the breakeven rate for that maturity, they should favour TIPS or ILGs. The inflation protection offered by these securities will be more valuable than what is currently priced in by the market. Conversely, if their inflation forecast is
  lower than the breakeven rate, they should favour conventional nominal bonds, as they will offer a higher real return if that low-inflation scenario materialises.
• A More Sophisticated Approach: As established in Section 3, a sophisticated investor should not rely solely on the raw breakeven rate. The optimal strategy involves first adjusting the breakeven rate for the estimated effects of the inflation risk premium (which inflates the breakeven rate) and the liquidity premium (which suppresses it). For example, if the observed 10-year breakeven rate is 2.25%, but an analyst estimates that the IRP is 40 basis points and the liquidity premium is 15 basis points, the net effect of the premia is +25 basis points. The “true” market expectation for inflation would therefore be closer to 2.00%. The investor should then compare their own inflation forecast to this adjusted 2.00% figure to make a more informed allocation decision.

5.2 Real Assets: A Strategic Allocation for an Inflationary World

When the yield curve signals a sustained risk of inflation, investors often turn to real assets, which possess physical value and cash flows that can adapt to a rising price environment.

The Rationale for Real Assets: Unlike financial assets, whose value is derived from a claim on future cash flows in currency units, real assets like real estate, infrastructure, and commodities have an intrinsic utility. Their ability to hedge inflation stems from their capacity to generate income streams that rise with the general price level.

• Case Study: Real Estate in High Inflation: Historical evidence from the high-inflation 1970s demonstrates the effectiveness of real estate as an inflation hedge. From 1978 to 1980, when U.S. CPI averaged 11.6% per year, equity REITs delivered average annual total returns of 23.1%, more than preserving investors’ purchasing power. The key mechanism is the ability of property owners to pass on rising costs to tenants through higher rents. This is particularly effective for properties with short-term leases (e.g., apartments, hotels) or long-term commercial leases that include explicit inflation-escalator clauses.
• Case Study: Commodities and Infrastructure: The link between commodities and inflation is often direct, especially during supply-driven price shocks. Energy commodities, in particular, have a strong positive correlation with headline inflation. Infrastructure assets can also serve as effective hedges if their revenue models are contractually linked to inflation. For example, a toll road may have a concession agreement that allows for annual toll increases tied to a price index, or a regulated utility may be permitted to pass higher fuel costs directly to its customers, protecting its profit margins and returns to investors.

Connecting the Strategy to the Yield Curve: The signals from the yield curve and breakeven rates can be used to time allocations to real assets. The most compelling case for increasing exposure to real assets arises when the yield curve is steepening and the breakeven inflation rate is rising. This specific combination indicates that the market is pricing in both strong economic growth (which benefits cyclical real assets like industrial properties and timber) and higher inflation (which benefits all real assets with pricing power).

This leads to a more advanced, dynamic strategy. Research has shown that while real assets provide a powerful hedge during periods of high and rising inflation, they can be a drag on portfolio performance during periods of low and stable inflation. A static, buy-and-hold allocation to real assets may therefore be suboptimal. Instead, investors can use the forward-looking signals from the bond market as a tactical trigger. A sustained steepening of the yield curve, coupled with a decisive upward trend in adjusted breakeven rates, would signal the time to overweight real assets. 

Conversely, a flattening or inverting curve accompanied by falling breakevens would signal that the inflationary threat is receding, suggesting a reduction in the real asset overweight. This transforms the simple idea of an inflation hedge into a sophisticated, signal-driven portfolio allocation rule.

Conclusion: A Synthesised View for 2025 and Beyond

The government bond yield curve, a reflection of the collective judgment of global capital, remains one of the most potent forward-looking indicators available to economists and investors. Its interpretation, however, is far from simple. The analysis in this report has demonstrated that while the shape of the nominal curve provides powerful signals about future economic growth, a deeper reading requires deconstructing yields to understand the market’s view on inflation. The breakeven inflation rate, derived from the spread between nominal and inflation-protected bonds, is the starting point for this analysis. Yet, this raw signal is itself noisy, distorted by time-varying inflation risk and liquidity premia that must be accounted for.

The historical contrast between the unanchored inflation regime of the 1970s and the anchored, low-inflation era of the 2010s underscores the paramount importance of central bank credibility. The behaviour of the yield curve, and its relationship with the real economy, is fundamentally different depending on whether the market believes policymakers have the will and ability to maintain price stability.

This brings us to the complex environment of mid-2025. The key market signals appear contradictory. The U.S. nominal yield curve is modestly inverted, with the 10-year Treasury yield at 4.36% trading below the 3-month Treasury yield of 4.46%. Historically, this has been a reliable harbinger of economic recession. At the same time, however, 5- and 10-year breakeven inflation rates are hovering around 2.25-2.30%, persistently above the Federal Reserve’s 2% target.

This is the central tension of the current moment: the bond market is simultaneously pricing in a cyclical economic slowdown and structurally persistent inflation. This suggests a partial erosion of the unwavering central bank credibility that characterised the 2010s. The market appears to believe that while a recession may be necessary to cool the economy, structural forces, such as deglobalisation, tight labour markets, and fiscal pressures, will prevent a full return to the low-inflation environment of the previous decade. This view is echoed in the cautious commentary of policymakers themselves, who acknowledge the upside risks to inflation even as economic activity shows signs of moderating.

For investors and analysts, this environment demands a sophisticated, non-binary approach. The traditional playbook for a recession, lengthening duration in fixed income, must be tempered by the risk that inflation will remain sticky, eroding the real returns of nominal bonds. Conversely, an all-in bet on inflation can be undone by a sharp economic downturn. 

The optimal strategy, therefore, is one of nuanced balance. Portfolios should be positioned to weather both slowing growth and stubborn inflation. This involves a careful allocation across high-quality nominal bonds for duration exposure, inflation-linked bonds for direct purchasing power protection, and a dynamic allocation to select real assets that can thrive in an environment where pricing power is paramount. The key to navigating this complex landscape lies in using the deconstructed signals from the yield curve, the slope for growth, and the adjusted breakeven rate for inflation, to dynamically manage these exposures, rather than making a singular bet on an increasingly uncertain future.