As the first part of this article discussed, a long series of hikes in short-term interest rates, in combination with recent rate declines on longer-maturity bonds, has created an unusual situation in which the shape of the yield curve is inverted. Historically, economic recessions have often (but not always) followed such periods. There are, however, some steps that you can take in this interest rate environment that can improve your own personal financial situation.
Loan options for borrowers
When the yield curve is normally sloped, rates on short-term loans are generally lower than rates on longer-term loans. This creates huge incentives for borrowers to use adjustable-rate mortgages instead of fixed mortgages. In early 2004, borrowers could lower their rates by as much as two percentage points by choosing the former over the latter.
With short-term rates having risen so dramatically since then, however, many borrowers who took out adjustable-rate mortgages in the past few years have begun to see their rates move higher. In addition, those seeking new mortgage loans now find similar interest rates, no matter what type of loan they consider. Recent data from Bankrate (Nasdaq: RATE ) indicates that rates on adjustable-rate and fixed mortgages generally fall within a quarter percent of each other. Rates on 15-year fixed loans and adjustable-rate mortgages are virtually identical.
This unusual situation gives borrowers a rare chance to replace an existing adjustable-rate mortgage with a fixed mortgage without paying a higher interest rate. Given their rising monthly payments, some borrowers might jump at the chance to lock in a fixed rate and avoid the risk that their payments might rise even further.
If you're in this position, be sure to do a little homework before you decide to refinance a fixed mortgage. You might gain stable payments, but you'll also surrender any possible benefit from future falling rates. Many analysts are starting to predict that increasing evidence of a slowdown in the economy will drive short-term rates lower. If you hold on to your adjustable-rate mortgage, you might see your monthly payments drop as a result.
In addition, find out whether your mortgage has a maximum rate that will never be exceeded, no matter what happens with interest rates. Known as a rate ceiling or overall cap, this rate defines your amount of additional risk in keeping your current adjustable-rate mortgage. If rises in interest rates have increased your mortgage rate to a level close to the rate ceiling, you don't have to worry about any further increases. If there's still more room for your rate to rise, a fixed-rate mortgage may be worth greater consideration.
Solutions for savers
On the other side of the coin, the inverted yield curve gives savers a rare opportunity to get rewarded for keeping their investments short. Some of the best deals around for savers are CDs that mature in one year or less. In contrast, it's nearly impossible to find similar rates on CDs with longer maturities. The usual situation, in which savers can lock in higher rates by tying up their money for longer periods of time, doesn't hold true when the yield curve is inverted.
This doesn't mean, however, that savers should give up entirely on longer-term fixed-income securities. Although you can temporarily improve your overall yield by moving all your savings into short-term investments, the danger in doing so is that if short-term rates drop substantially, you'll be forced to reinvest maturing investments at those lower rates. Depending on how much short-term rates drop, you may end up wishing you'd bought a five-year CD, even though it didn't pay as much as your matured one-year CD did. For those who use bond ladders to take advantage of normal yield curves and manage their interest rate risk, a temporary inversion in the yield curve probably doesn't justify a major change in your strategy.
In addition, the inverted yield curve gives investors who previously stuffed their portfolios with longer-term fixed-income securities a chance to rebalance toward shorter-term investments without suffering a current loss of yield. Under ordinary conditions, selling long-term bonds and replacing them with short-term bonds results in less income. However, when short rates top long rates, this move can actually increase income slightly. Again, bear in mind that you retain more reinvestment risk with short-term securities, and so over longer periods of time, you may not be able to sustain current levels of income. On the other hand, if the yield curve resumes its normal slope because long-term rates rise substantially, decreasing your exposure to long-term bonds will reduce your exposure to the falling bond prices that would result from rising rates.
Inverted yield curves don't often appear. Although they represent an ominous sign for some economic analysts, investors and borrowers can take advantage of the opportunities that they bring to make changes in their saving and borrowing strategies. Even if you decide that your current situation requires no action, a closer examination of your investing strategies will leave you better-positioned to respond to future economic changes most effectively.
Further non-inverted Foolishness:
The intricacies of fixed-income securities can be hard to figure out on your own. That's why the Fool created its Bond Center, which contains a wealth of helpful information that will guide you in learning about bonds and how to use them in your investment portfolio.
Fool contributor Dan Caplinger used to own an inversion machine, but hanging upside down like a bat lost its appeal after a while. He doesn't own shares of the companies mentioned in this article. Bankrate is a Motley Fool Rule Breakers pick. The Fool's disclosure policy works upside-down, inside-out, and round and round.