You probably have heard a lot about the yield curve in the past; especially when it was inverted and Greenspan could not move it despite his best efforts. But what is the yield curve and what does it mean to you, particularly investors?

To give you a little background, bonds are the financial instruments that lending markets are based on. They determine the interest rates you pay on cars, homes, boats and other loans. They come in various lengths (maturities) and risk levels (credit quality). These different types move in different ways, sometimes even opposite of each other. Depending on the length of the term, they may have different names, such as T-Bills are up to one year, T-Notes up to 10 years and Treasury Bonds being the longer terms. Mortgages are driven by Mortgage Backed Securities such as the FNMA Bonds.

Since time is money, the yield curve provides a visual representation of interest rates on similar credit quality bonds of varying maturities. As a result, the yield curve reflects the relationship between the amount of time over which money is being borrowed and the cost of borrowing that money. Generally, the longer the maturity, the higher the return expected. To see today’s yield curve, just graph the yields of today’s market.

Typically, the yield curve becomes steeper at the beginning of a “tightening cycle”, the time when the Fed is raising the Fed Funds Rate (short-term money). This is the result of the long term economic outlook improving and that the Fed is worried about inflation. The curve becomes steeper as long term investors demand larger rates of return (higher yields).

So, what is the deal with an “inverted” yield curve? Well, it symbolizes the fact that investors are concerned about the economic outlook. If investors get scared of the future, they move their money from the short term investments to lock in higher yields on long term investments. This drives the prices lower on short term investments, resulting in higher yields on those investments. When yields are even across the maturities (or at least close to it), we have a flat yield curve. If short term investment yields go higher than the long term investments, then the yield curve has gone “inverted”.

The yield curve translates to the mortgage market on several levels. First, long term investment yields translate to the interest rates offered to you, the borrower. Second, in an inverted or even flat yields curves, the benefits of Adjustable Rate Mortgages (ARMs) may get minimized, even eliminated. So, your current mortgage, which was right for you last year, may not be the right mortgage for you this year, depending on the curve.

So, where are we today and where are we headed? Well, the Fed was raising short term rates in an effort to cool the economy. Long term rates did not rise as quickly and so we had been in a flat yield curve during this last tightening cycle. Long term rates have risen in the last few months, so we have a slight curve, though still relatively flat. With all of the volatility in the markets right now, the exact direction cannot be determined, but since our economy is moderating, I suspect we will remain relatively flat for a while. Keep an eye on the stock market because if the Bulls take control, long term rates will likely be heading higher and a steeper curve will develop. Economic data also drives the yields, generally with rates moving the same direction as the potential for inflation (higher chances of inflation and strong economy, higher rates).