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Interest Rate Report - February

recent interest rates for 30 and 15 year fixed rate mortgagesMortgage Rate News

In spite of ominous predictions, fixed mortgage rates fell slightly in December and January - about a quarter of a percent.

 

     Analysis:

An important event occurred on January 26th. 

The "inverted yield curve." 

Sounds boring, doesn't it?  Well, it is sort of boring -- but understanding the inverted yield curve may give you an edge over your neighbors in anticipating the future.

January 26 was the day that the yield on six-month treasury bills was 4.54%.  The yield on ten-year treasuries was 4.53%.  That's unusual and that is why January 26 is important.

We'll explain.

Short-term rates are normally lower than long-term rates, not higher.

Suppose you choose to put money in a certificate of deposit at your local bank.  Unlike a regular savings account where you can easily withdraw your funds if you need them, a certificate of deposit ties up your money for a specific period of time. 

If you're tying up your money for ten years, you would expect to earn a higher rate of interest than if you were only tying it up for six months - and that is the normal situation - because longer term investments carry higher risk.  Inflation may skyrocket, we could fight a war, the bank may go under, we could experience a middle-east oil embargo, or a tidal wave could hit one of the coasts.

If you were to look at "normal" interest rates on a graph, the line representing longer term investments would be higher up on the graph than the line representing shorter term investments.  Those lines on the graph are called "yield curves."

On January 26, for at least a brief period of time, the "yield curves" of long and term and short term treasury were opposite of where they should normally be.

They were inverted.

The line representing short-term rates was higher on the graph than long-term rates.

When short-term rates are higher than long-term rates, it is called an "inverted yield curve."

Why is this important?

To simplify, banks borrow at low interest rates by paying you interest on savings accounts and certificates of deposit.  Then they lend that money out on mortgages and such at higher interest rates.  That's how they make money.

Actually, it is much more complicated than that, but you get the idea.

As the bank's cost of borrowing gets closer to how much they can earn from lending, they earn less profit.  Since they earn less profit , they are less willing to lend.  The money supply dries up.  So much of our economic growth is  based on spending driven by consumer and business borrowing that the economy begins to slow.

Since 1970, every recession has been preceded by an inverted yield curve.

Every recession.

Of course, it takes a while for the slowing economy to result in a recession.  The average time between inverted yield curve and recession is 40 weeks.

The Fed has been gradually raising short-term rates since June 2004.  Fourteen rate increases at .25% a pop.  Short-term rates have increased by 3.5%. 

The reason they raise rates is to prevent the economy from "overheating" so much that inflation becomes a threat.  Inflation devalues money so that it isn't worth as much as it used to be.  That causes people to want higher interest rates on their savings and banks to want higher returns on their loans.

By raising short-term rates, the Fed hopes to slow the economy "just enough" to create a "soft landing" rather than a recession and that helps to keep interest rates low -- even though the Fed is raising interest rates to accomplish the goal.

Many critics think the Fed tends to overshoot and raise rates "too much."

Like now, perhaps.

That is why "inverted yield curves" are important.  They are an economic indicator of the economy's future performance.  Of course, they are just one indicator and very few economists are willing to predict a recession based on just that indicator.

Which is the reason for the old joke about the exalted corporate executive who wishes for a one-armed economist. 

A one-armed economist couldn't say, "But on the other hand...."

 

Interest Rate Future

 

Although it is quite likely that rates will float upwards at some point in the near future, there will probably be no drastic moves to the up side.  More likely, you can expect a fairly stable situation with small fluctuations up and down.

 

View Current Mortgage Rates

View February's Report on Existing Home Sales and Prices

 

     
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Last modified: January 27, 2006 02:53:35 AM

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