Mysteries of the yield curve revealed!

Falling interest rates are hurting cash investors, while mortgage hunters are seeing rates inch higher. How can that be? Blame it on yield-curve whiplash.

The yield curve, simply put, is what results when you graph the relationship between interest rates and different maturities. In normal economic times, the yield curve slopes upward because investors demand a greater return for locking up their money for a longer period.

When the shape of the curve changes, however, watch out. Research shows that inverted yield curves, in which long-term rates fall below short-term rates, have preceded every recent economic recession. That predictive quality has made the yield curve one of the must-watch statistics for economic analysts -- because as it goes, so will the economy.

We had an inverted curve six months ago, just before the economy went into a funk. But by three months ago, rate cuts by the Federal Reserve Board had begun, and the curve began to flatten. Now, it's moving swiftly back to a steep incline.

Many Treasury and CD yields are now the lowest in seven years and appear headed lower with an additional rate cut on the horizon. Short-term yields have been falling precipitously as the rate cuts have continued because investors require a lower yield in a falling rate environment than when rates are rising.

On the opposite end of the curve, long-term yields have rebounded from the 4.8 percent level to 5.25 percent in recent weeks as the prospects for economic recovery brighten. This is the phenomenon behind rising mortgage rates, even as interest rates are cut.

The activity seen in the Treasury yield curve carries over to CD maturities of a similar term. Short-term CD yields continue to fall, by 60 basis points in the past 60 days.

In this week's Bankrate.com national survey, 40 percent of institutions cut yields on CDs of one year and less. Just 8 percent of institutions cut yields on five-year CDs, with an equal amount raising yields as cutting yields. It's not that longer-term CD yields haven't fallen -- they're down about half as much as shorter-term CDs over the same time period. It's just that longer term CDs fell earlier and faster than their short-term CD cousins.

With short-term yields falling faster than longer term yields, investors must be cautioned not to alter their investment strategy. Why? Investors run the risk of locking up too much, for too long, for too little yield. The temptation may be difficult to resist when institutions run specials on longer-term CDs, while cutting short-term yields.

Those investors who have painstakingly constructed a laddered CD portfolio are now reaping the benefits, as only a portion must be reinvested in the current market, with yields the lowest since 1994. Much as a diversified stock portfolio has protected against the carnage in tech stocks, diversifying a cash portfolio by laddering offers protection from reinvesting the whole bundle when yields are low. What's more, investors still possess a portfolio tailored to their cash requirements.

Where does an investor go to maximize yield? Bankrate's 100 Highest Yields list includes certificates of deposit with yields high enough to more than offset the state income tax exemption on earnings from Treasury securities. Safety of principal is assured, as all institutions listed are FDIC-insured.

Greg McBride is a financial analyst for Bankrate.com.

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