Interest rates are basically the price of money over a given time period. Accordingly, interest rates play a very important role in financial analysis as the cost of money over a given time horizon is the foundation of time-value-of-money calculations which is itself the foundation of financial theory. Therefore, investors pay a lot of attention to changes in interest rates. For example, there is constant focus on Federal Reserve policy and whether the Fed is likely to increase or decrease short-term interest rates, because a change in interest rates will impact many financial models and can have a big impact on the perceived value of financial assets such as stocks, bonds, real estate, and even commodities.
A yield spread is the result when one interest rate is compared to another to determine certain relationships between the rates. Often, important information can be extracted from these relationships although, as with all financial and economic indicators, they are not 100% accurate (see next article on the Federal Reserve Yield Spread Recession Indicator). In other words, the data extracted is not necessarily a prediction of the future but rather an indication of what investors are thinking as their outlook is priced into the markets.
One interesting yield spread that may offer some insight into future markets is the 5-year Breakeven Inflation Rate. This measures the difference between nominal 5-year Treasury bond rates and 5-year Treasury Inflation Protected Securities (TIPS) rates. The difference between the two rates should approximate the expected inflation rate going forward, as the only difference between nominal Treasury notes and TIPS is that TIPS offer an additional return based on the rate of inflation. Currently, the 5-year Inflation Breakeven has increased from 2.22% in late 2025 to 2.66% currently. In other words, the market has priced in an average of nearly 0.5% in higher inflation over the next 5 years, or that prices will be 2.2% higher after 5 years.
The increase in inflation expectations is obviously a result of higher oil and other commodity prices. However, since the increase in the inflation breakeven rate increased by a fairly small amount given the increase in actual current inflation, the market may be pricing in that the increase in inflationary pressure may be short-lived and thus moderate later in the 5-year period being measured. Still, this poses an increased risk which needs to be monitored.
Another yield curve spread which is worth monitoring is the spread between 1-year Treasury bond yields and the interest rate paid by bonds that are rated BBB (the lowest credit rating that is still considered high quality or investment grade). When investors are concerned about the future economic climate, they demand a higher yield spread to compensate for the higher risk of lower credit rate bonds. When the concerns about economic risk are low, investors may accept a much smaller premium yield over and above Treasury bond risk to compensate for the higher risk because the expectation is that the risk will not materialize in the short-term.
Currently, the Treasury to BBB Rated Bond Spread has been falling, signaling expectations for strong economic growth. The yield spread started the year at 1.76% and is currently 1.59%. All of these are low levels. Historically, investors should be concerned when the yield spread exceeds 3%, which has historically signaled a high risk of a recession.
The bond market is signaling higher inflation, although modestly, but is also signaling that the US economy is likely to remain strong despite some of these increased risks. Of course, these indicators should be monitored constantly for signs of changing sentiment in the markets which may be a sign of the future path of interest rates as well as asset prices.