Yields Finally Flip -- Officially

It's official, folks. The yield curve officially flipped on December 27th, when the yield on the two-year treasury bill edged up to 4.35 percent while the yield on the ten-year treasury bill fell to 4.34 percent.

Such an occurrence is unusual and counterintuitive. Logically, investors demand a higher return for a longer commitment. This is why, for example, 30 year fixed rate mortgages will carry a higher interest rate than one year ARMs. The Federal Reserve Board has considerable control over short-term rates, but very little control over long term rates, which are largely controlled by market forces.

Here's what's happening: The Fed and the market are butting heads. The Fed has raised short-term rates 13 times in the last 19 months, in an effort to balance economic growth and inflationary pressures. Long term rates have barely budged. Apparently the market doesn't feel the same inflationary pressure that's felt by Chairman Greenspan and his "Merry Band of Policymakers."

Over the last year or so there have been many short-term rates carrying a higher yield than their longer-term counterparts. Take the prime rate for example. The prime rate affects many consumer loans and most home equity lines of credit. It can be considered a short-term rate because it is directly affected by the monetary policy of the Federal Reserve Board. In fact, the Fed's latest credit tightening campaign over the last 18 months has pushed the prime rate up from four percent to the current rate of 7.25 percent. Meanwhile, 30 year fixed rate mortgages are hovering around six percent.

While this is just one example of a short-term rate exceeding a long term rate, the media didn't focus on the phenomenon until December 27, when the two year treasury bill surpassed the ten year note.

Suddenly the inverted yield curve became big news.

Now, how does all this affect real estate and mortgages? First, adjustable rate mortgages are no longer the bargain they once were. In fact, you'll probably discover that the rate on a three-year ARM, which carries a fixed rate for the first three years, is higher than the rate on seven-year ARM, which carries a fixed rate for the first seven years.

Let's look at the big picture. The stock market fell sharply on December 27th because an inverted yield curve has historically been followed by a recession. Some economic talking heads have publicly insisted that it won't happen this time. Others are siding with history and predicting slower growth by mid-2006.

For homeowners and future homeowners, I can tell you that a weaker economy, whether or not it's called a recession, tends to keep inflationary pressures in check. When inflation is kept at bay, interest rates often fall across the board.

If we are indeed headed for an economic slowdown in 2006, homeownership may become more affordable, not just a result of the cooling housing market, but lower mortgage rates. Stay tuned.
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