Which scenario best illustrates a potential recession according to the yield curve?

An inverted yield curve is the scenario that best illustrates a potential recession. This occurs when long-term interest rates are lower than short-term rates, signaling that investors expect economic slowdown or recession in the near future. An inverted yield curve suggests that the market lacks confidence in the short-term economic outlook, leading to a higher demand for long-term bonds, which drives down their yields.

In contrast, a flat yield curve indicates that there is little difference between short-term and long-term interest rates, often reflecting uncertainty in the market rather than a clear signal of impending recession. A normal yield curve, where long-term rates are higher than short-term rates, typically represents a growing economy. A steep yield curve indicates strong economic growth expectations, as investors demand higher yields for longer-term investments due to rising inflation expectations or an increasing rate environment.

The inverted yield curve serves as a more reliable indicator of a potential recession and is often monitored by economists and financial analysts to gauge future economic conditions.