The magic yield curve shows a higher-rate future
By Michael D. Larson • Bankrate.com

It may seem like economic wizardry to mortgage Muggles out there. But the somewhat arcane "yield curve" may foretell the direction of loan rates over the next few months better than anything else. Right now, its view of the future ain't so good and that's yet another reason borrowers should strongly consider locking in today's low rates -- before they vanish!

First, with apologies to J.K. Rowling and Harry Potter fans everywhere, here's a little background from the Mikewarts School of the Economy:

There are a handful of major debt securities that trade every day on Wall Street. They include the three-month and one-year Treasury Bills, the 10-year Treasury Note and the 30-year Treasury Bond.

Market watchers like to take the yields on each of those securities and plot them graphically. The left side of the graph shows a scale of yield numbers (4.6 percent, 4.7 percent, etc.) and the bottom of it shows which bonds (one-year, 10-year., etc.) offer those yields. The image that results from this plotting is the yield curve.

Normally, the yield curve looks like a line that slopes up and to the right (kind of like charts of the Nasdaq until early last year!). That's because yields on short-term bills are typically lower than yields on long-term bonds. After all, it should cost borrowers more to borrow money for 30 years than it does for them to borrow for one year because the risk of problems popping up (default, rising inflation, etc.) over 30 years is greater than the risk of them popping up over the next 12 months.

But when the economy is starting to slow, the yield curve typically "inverts" and starts looking like the second half of an upside-down "U."

Why? Consider that the Federal Reserve Board's main tool to control the economy is the federal funds rate. When it raises that short-term rate, rates begin to increase across the entire yield curve. But as those rate hikes begin to take effect and the economy stars to slow, long-term rates start dropping.

The reason is simple: Investors realize the Fed will eventually have to cut rates in order to get growth going again. They start clamoring for long-term bonds to try to lock in the highest yields possible for the longest possible period before those cuts take place. That drives demand for long-term bonds higher and yields on those bonds lower.

At the same time, the Fed hasn't started cutting rates yet. Since yields on short-term debt closely follow the current funds rate rather than what that rate is expected to be in the future or how the economy is expected to perform down the road, they remain high.

So to make a long story short, an inverted yield curve often signals that the economy is in the process of slowing.

Last year, for instance, the yield curve inverted long before government and private-sector reports started to show signs of significant economic weakening.

People first attributed the inversion to the government's moves to pay off long-term debt. But later on it became clear that fundamental economic reasons played a significant role, too.

Unfortunately for mortgage hunters, the yield curve has reverted to its traditional shape over the past several days. That typically signals an economic rebound is coming. Already, rates have risen somewhat and that trend will continue unless, as some market watchers say, this is just a short-term phenomenon.

Borrowers looking for long-term fixed-rate mortgages have to be ready to lock in whenever a weak day in the stock market or a weak economic report sends rates down a bit.

Those who need short-term adjustable rate mortgages, on the other hand, may still be able to get lower rates because rates on those loans haven't fully reflected recent Fed cuts and the one or two more cuts the Fed's expected to push through. But even they are probably nearing a bottom. With it looking more and more like the long-term direction for rates is higher, waiting for significantly lower rates is like practicing magic outside the castle -- a surefire way to get in trouble.

"The yield curve is a classic and fairly reliable indicator of where the economy is headed," says Richard DeKaser, chief economist at Cleveland-based National City Corp. "You see a diminishing slope or inversion as you anticipate a slowing in the economy and you see steepening when the economy is perceived to be entering a period of improving growth."

"Long-term interest rates, I believe, are beginning their move upward."