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Watches for Changes in Economy with Inverted Yield Curve

Relationship of Long to Short Term Rates Is Important Indicator


There are hundreds of stock market and economic indicators for you to watch, but which ones are the most important?

There will always be debate about the importance of indicators, however there are a few that most market observers agree are important.

The Treasury bond yield curve sounds mind-numbing complex. But, it is one of those indicators that you should pay attention to.

Here's why:

It is a well-understood fact that investments locked in for a longer period pay more than shorter term instruments.

This is illustrated in the bond market and, also in the bank certificate of deposit market.

A six-month CD is usually offered at a lower interest rate than a three-year CD.

The reason is fairly obvious - the longer you hold a fixed interest rate investment (such as a bond or CD), the greater risk you have that something bad will happen and lower the value of you investment.

For example, if you find a bank CD that pays 5 percent for a three-year term, you are exposed to the risk that interest rate could rise during that period and you will miss the opportunity for a higher rate of return.

Bank CDs often have a penalty for early withdrawal, which would make it unwise to cash one in early for an extra percent return or so.

In the bond market, you usually can sell the instrument whenever you want, however if interest rates have climbed since your purchase, you will have to sell the bond at a discount to find a buyer.

The U.S. Treasury bond yield curve looks at the rates for two-year and ten-year bonds.

If investors are concerned about the future, they won't buy longer termed bonds (the longer the term, the greater the risk).

When the economy is uncertain, few investors want to tie up money for long periods.

The stock market watches the yield curves and looks for one of three main types.

The normal yield curve shows long-term bond rates higher than short-term bond rates. This indicates a stronger confidence in the near-term for the economy and less confidence farther out.

This follows common sense and the appropriate relationship to risk of short and longer-term bonds.

When the difference between short and long term bonds widens it means investors are willing to risk tying up their money for a longer period.

The second yield curve is called the flat curve (which doesn't sound correct - how is a curve flat?). The flat yield curve occurs when short and longer term rates are very close.

It is considered a sign of change in the near future and is viewed with caution by the investment community. It may signal the third type of yield curve: the inverted yield curve.

If the investment community is really worried, the longer term bonds can actually go for less than short-term bonds, which is a reversal of the normal relationship.

This so-called inverted yield is often a sign the market thinks the economy is in trouble or higher interest rates are approaching.

You will hear or read in the media if an inverted yield curve presents itself, since the markets consider a harbinger of economic change for the worse.

Another consideration is the slope of the curve. If there is a wide gap between the long and short-term rates (steeper slope), it expresses more confidence in the economy.

A flattening of the curve suggests a change is anticipated, such as higher interest rates.

If interest rates appear poised to be rising, investors do not want to be tied down with low interest bonds.

You can find the Treasury bond yield curve information at CNN.com.

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