ARM's are on their way back

Mortgage and Lending

I'm going to take a moment to get technical and talk about the yield curve on US Government bonds, bills and notes; specifically, I'm going to address what an inverted yield curve is and why it's important to you.

The yield curve is a graph that plots yields (that's an interest-rate adjusted return on a bond) vs. maturity length for the bonds that the U.S. Government issues when it borrows money.

Here's a peek at the yield curve as reported by yahoo's finance site this morning:

Yields on the 10-year treasury

Not very exciting, as curves go. It's almost flat -- it shows that the market expects about the same return on long-term, fixed interest rate securities as it does for short-term securities.

Missing from this graph is the Fed Rate -- the rate at which banks borrow from one another overnight in the US banking system. Since June of 2006 it has stayed level at 5.25%, to which it was raised by 17 consecutive rate hikes as our economy recovered from 9/11.

An inverted yield curve is one in which short-term yields are higher than long-term yields -- and it presents a question (put succinctly by the good people at Fidelity:

Why would long-term investors settle for lower yields while short-term investors take so much less risk?
The answer is that long-term investors will settle for lower yields now if they think rates -- and the economy -- are going even lower in the future. They're betting that this is their last chance to lock in rates before the bottom falls out.

An inverted yield curve is one in which the market believes that the economy is going down.

Now here's an interesting historic note: Since 1954 (when we first started keeping track of this kind of thing), inverted yield curves have never righted themselves without the Fed lowering interest rates. And with a couple of momentary exceptions (like we had in recent weeks, when the yield on the 10-year climbed to 5.32%), we've had this inverted yield curve since April of 2006.

And how has our economy fared with this inverted yield curve? Real GDP growth for the first quarter of 2007 was only 1.9%, down from 3.7% for the same quarter in 2006.

To quote Bloomberg's Caroline Baum,

The impact comes from the fact that the Fed is holding the short-term rate too high relative to the market-determined long-term rate. Until the spread turns positive on a sustained basis, by either the Fed's or the market's action, the economic outlook is for more of the same.

Stepping back from the bond market, this all feels much closer to home if we consider the remarkably parallel mortgage interest rate market (it may not surprise you that they're parallel, considering that long-term mortgage rates are based on the 10-year treasury.) Before this quarter's dramatic spike in 30-year fixed interest rates, many borrowers found that 3 year ARM's were actually more expensive than 5-year ARM's (that's inverted, isn't it? you would expect a shorter fixed interest rate period to have a lower rate) -- and 5-year ARM's saved very little money as compared to 30-year fixed mortgages.

That's why borrowers came in droves to refinance out of their ARMs: As Fidelity says, they were "betting that this [was] their last chance to lock in rates before the bottom [fell] out."

Here's why this is important to you: The days of cheap 30-year fixed rate mortgages could be coming to an end. The Fed has shown that they're nervous enough about inflation that they don't want to lower rates any time soon, so this inversion will likely right itself through market forces, if it does at all.

That means that ARM's -- which have come under such fire lately -- will once again present a compelling financial question: "How long do you know you're going to want to be in this loan?"

Adjustable rate mortgages are on their way back. Only this time, let's be more responsible with them.

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Tony D. Howell
The best place EVER! - Wilmington, NC

Great post!  Some of my realtors ask me what I mean when talking about an inverted yeild curve and this explains it quite well.

Jul 02, 2007 03:21 AM #1
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