Yield Curves and Inverted Yield Curves.

Yield Curves and Inverted Yield Curves

Q. In past newsletters you’ve spoken about “an inverted yield curve”. What is it? and of what significance is it to borrowers?

A. The yield curve is the gradation of interest rates from short term to long term. Like a lower case “r”, it usually slopes upward and to the right; that is, with shorter term mortgages having smaller yields and longer-term mortgages having higher yields. Typically in economics, everything comes down to risk vs. reward. In the normal course of events, one would naturally expect to pay a higher interest rate the longer the term of the loan because the lender’s money is at risk for a longer time. In 2005, we’ve have had pricing anomalies in the mortgage markets whereby the interest rates for adjustable rate mortgages(ARMs) with fixed-rate terms of 1 year were more expensive than 3/1 ARMS and both were more expensive than 5/1 ARMs. The yield curve is inverted when short-term yields are higher.

Any time one can borrow money for longer terms at a lower rate than shorter terms, it behooves one to do so because as the proverbial wisdom goes, “a dollar today is worth more than one tomorrow”. An inverted yield curve is when shorter term money is priced higher than longer term money, for example, the 2-Year Treasury Note Yield moved higher than the longer term 10-Year Treasury Note Yield a while back. Of late, the price differential between the 7/1 ARM and the 10/1 ARM and a 30-year fixed-rate mortgage has been as slight as an 1/8 of a percent. Why does anyone care….because inverted yield curves have been viewed as a precursor of real trouble, heralding slowdowns at best and recessions at worst. The implication here is that investors do not feel sanguine about the long-term strength of the economy.

Also, the same factors that influence the interest rate climate in the U.S are have similar global effects on overseas bond markets. The yield curves in Japan and Germany, the second and third largest economies in the world, have been flattening, while the yield curve in Britain has already inverted. Long-term interest rates are even lower in Europe and Japan than they are in the U.S.

Remember, too, that money invested in the market tends to flow back and forth between the stock market and the bond market, on which home loan rates are based. When good news for the economy comes out, money flows out of bonds and into stocks, as investors are looking to maximize their return with stocks and stand to make a return better the 4-6% they’re apt to get from bonds. And when money flows out of bonds, prices worsen because the yield (interest) on bonds is inversely related to its price so as the price drops the yield increases…thus home loan rates, in turn, worsen.