It ’ s Your Money
many economic indicators , believes that is the case , they will start to increase short-term interest rates , which may or may not lead to higher long-term interest rates . Why the contradiction ? If the bond market believes that the Fed is too slow in raising interest rates , the market will bid up long-term interest rates because it believes inflation will keep going higher . If the bond market believes that the Fed is too fast in raising rates and believes this will slow down the economy , it will bid down long-term interest rates – the so called “ bear flattening ” which I briefly touched on in my last article . This is because the market believes the higher interest rates will slow down the economy and the next move the Federal Reserve will make is to either keep rates steady or lower rates . Again , this is a balancing act the Fed does with each meeting .
So , how do you use the yield curve to your advantage ? Well , it ’ s simple and not so simple . If you believe interest rates are going to continue to go up , you should only invest in short-term vehicles , so you can take advantage of higher interest rates at a future date . If you believe that interest rates have peaked and interest rates will start to decrease , that is when you buy longer term bonds to lock in those higher interest rates . Let me give you an example of how volatile things can be over the short term . Over the last several weeks , the stock market has dropped more than 1,000 points and the yield on the 10-year Treasury bond has decreased from 3.7 to 3.25 percent . The European financial crisis caused a selloff in stock markets around the world , including the United States . As people sold their stocks , they were looking for a safe place to put their money , so they bought bonds causing the price of longer term bonds to go up and yield on those bonds to go down . Several articles ago I wrote an article on stock market indicators where I explained that the McClelland Oscillator and Summary Index were very high and the VIX was very low , both predicting a fall for the stock market and sure enough , it happened . As a matter of fact , it wasn ’ t that long ago that the 10-year Treasury bond was yielding over 4 percent . Bond traders who bought those treasuries would have seen a very nice capital appreciation in those bonds during that one percent interest rate drop . Of course , one is not thinking short term when one purchases a 10-year bond .
There are several things to keep in mind . Number one is that the yield curve is presently predicting higher interest rates . The federal funds rate has never been lower ( 0-0.25 percent ) and rates have nowhere else to go but up . Secondly , because our national debt is so high , there is some talk of the credit rating of the United States being downgraded . If that should happen , countries that finance our debt , especially China , may demand higher interest rates to compensate them for the increased risk they are taking . Look what has happened to Greece . Fortunately , the United States is nowhere near the Greece situation , or at least not yet , but one never knows what the future will bring . In a future article , I will discuss strategies you can use for investing in bonds , regardless of where interest rates are going .
Finally , not only can we use the yield curve in deciding when and where to invest , the yield curve is also very useful in borrowing money . For example , if you are looking for a mortgage or looking to refinance a mortgage , watch the yield on the 10-year treasury . This is used most often in setting mortgage rates . Lock in long-term rates when the yield is low as it is today . If you have an adjustable rate mortgage , now is the time to refinance and lock in those low rates . When rates are high on the 10-year treasury that may be a good time to take an adjustable rate mortgage hoping for lower rates in the future . Nothing is a given when it comes to interest rates and where they are going , but understanding the yield curve is one more tool you can use to help increase not only your investment success but also your borrowing costs .
50 November / December 2010 • Pennsylvania Dental Journal