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The Inverted Yield Curve and You

Interest rates have made plenty of news lately, with frequent speculation about where they've been, where they are now, and where they're headed. After 17 straight hikes in the federal funds rate by the Federal Reserve since 2004, short-term interest rates have stabilized. Meanwhile, longer-term interest rates, which didn't fall as much as short-term rates did in 2002 and 2003, have also not risen as much as their short-term counterparts in the latest rate cycle. In fact, since June, rates on 10-year Treasuries have actually fallen substantially, by nearly three-quarters of a percentage point.

Now, some commentators are arguing that current rates predict a downturn in the economy. The existence of what's known as an inverted yield curve has indicated slowing economic growth and recessions in the past. Regardless of its potential effect on the overall economy, an inverted yield curve also has specific implications for both borrowers and investors in fixed-income securities.

About the yield curve
Different types of fixed-income securities have different characteristics, including interest rates and maturity dates. Depending on your time horizon, you can buy fixed-income securities from the U.S. Treasury that mature as soon as next month, or as long as 30 years from now. Some private issuers have bonds with even longer maturities; Disney (NYSE: DIS  ) and IBM (NYSE: IBM  ) have recently issued 100-year bonds. The length of time until the bond's maturity is one factor that helps to determine the rate the issuer will pay on the bond.

By graphing the rates of bonds of various maturities, you can create a yield curve. Generally, the yield curve graph has rates on the vertical axis and maturities on the horizontal axis, with short-term rates on the left and long-term rates on the right. (See an example of the current yield curve, along with some interesting tools to view historical yields.)

Most of the time, the yield curve will be a broken line that goes from the lower left to the upper right. Under normal circumstances, interest rates on shorter-maturity fixed-income securities are lower than interest rates on long-term bonds. Intuitively, this makes sense; long-term bonds require investors to lock up their money for a longer period of time, and investors will generally want a higher return to compensate them for surrendering access to their investment capital.

However, short-term rates occasionally rise above long-term rates. This is the case now, with short-term Treasury bills yielding more than 5% while longer-term Treasury notes and bonds yield closer to 4.5%. Because this makes the yield curve go from the upper left to the lower right, commentators refer to the resulting yield curve as being inverted from its normal orientation.

Some implications of inverted yield curves
At first glance, an inverted yield curve doesn't make much sense. If rates on bonds with shorter maturities are higher than rates for longer-term bonds, it's not immediately clear why anyone would continue buying longer-term bonds. In response, long-bond prices would fall, and yields would rise to the point at which the yield curve was no longer inverted.

However, there are some circumstances under which an inverted yield curve makes sense. Consider an investor who wants to save some money for two years using Treasury securities. They could simply buy a single two-year Treasury note, or buy a succession of six-month Treasury bills, purchasing a new one every time their current bill matures.

If the investor goes with a two-year note, the interest rate on that note is known at purchase, and it'll stay constant during the entire two-year life span of the bill, making it easy to figure out the precise return. However, if the investor uses six-month bills, it's impossible to know exactly how much the investor will have at the end of two years. While the investor knows the rate on the most recently purchased bill, there's no way to predict what the interest rate on six-month bills will be six months from now, or next year, or in 18 months. If the investor believes that interest rates will drop dramatically, it would make sense to buy the two-year note, even if its rate isn't as high as that of a six-month bill.

Economists have noticed that nearly every economic recession in the United States has been preceded by a period during which the yield curve was inverted. However, the converse is not necessarily true; not every inverted yield curve has resulted in a recession. On the other hand, recessions have followed inverted yield curves often enough that a yield curve inversion is seen by many analysts as an important leading indicator of the possibility of a severe economic slowdown.

Although it's difficult to predict exactly how future interest rates and financial markets will respond to the current inverted yield curve, savers and borrowers can capitalize on several opportunities right now to potentially increase returns on investments, save interest expense, and reduce risk on their credit. The second part of this article examines these opportunities in detail, and gives you practical advice on how to benefit from the current interest rate environment.

A constant rate of further 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 contributorDan Caplingerused 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. Disney is a Motley Fool Stock Advisor pick. The Fool'sdisclosure policyworks upside-down, inside-out, and round and round.

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