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The yield curve is an important graph when doing investments.

It basically describes the yield you get for bonds, for different durations. From an investor's point of view, it is natural that for a 10 year bond, you get a higher yield than for a 2 year bond. You commit yourself to a longer time frame and take risk on two points: Can the issues of the bonds go bankrupt? Or, if I have to sell the bond in the mean time and the current interest rate is higher, my selling price would be lower. Both risk scale with the duration of the bond.

So when the yield curve inverts, i.e. the yield for a 10 year bond is lower than for a 2 year bond, then you should pay attention. The central bank can adjust the overnight interest rate and will do so to curb inflation. By selling bonds and thus taking money out of the market, the inflation pressure is reduced and the rates go up. This trickes down through the different bonds.

So when the yield curve inverts, the general reasoning is that the central bank is slowing down the economy by reducing the amount of money in the system and thus suppressing inflation. That would also mean that the growth of the economy will slow and that it is a good time to sell your stock and buy bonds.

However, this may not always be the case. When the absolute level of the interest rate is still low, i.e. accomodative as it is called, the economy is still encouraged to grow more rapidly than its natural pace.

This is a long standing discussion between economists. It is related to the US deficit issue. The US has a very large deficit with foreign countries. However, it is unclear who is doing what. Is the US consumer consuming too much or is there a savings glut in the rest of the world? If the US consumer is consuming too much, then foreigners are more or less forced to buy US bonds to finance the export industry and no real gain is accumulated by exporting countries. To offset this pressure, the US should offer a higher interest rate, especially on the short term bonds. On the other hand, if there is a savings glut in the rest of the world, there is a lot of money floating around that is looking for a good investment opportunity. 10 year US bonds would be such a steady investment, and that would depress the yield of the 10 year bonds.

Bernanke says there is a savings glut, a lot of other economist say the US is consuming too much.

Which one is it? Econbrowser: The yield curve and predicting recessions