What does a Flat Yield Curve Mean to You?

If you read the financial section of the newspaper you will see a reference to "yield curve" all the time. What does that mean to you? Is it important? How does it affect your decision-making? These are actually important issues for homeowners and you should know more about this.

As an investor, the longer you tie your money up, the more of a return you would want. I’ll make these numbers up but if you had a savings or money market account with instant access, you might be happy with a 3% return. But if you were in the market for a 5-year CD, you’d certainly want more than 3%, maybe 5%, to compensate you for the extra risk of having your money tied up that long. What about lending it out for 30 years? Well, no one I know would want to do that.

It turns out that everyone else is just like you. Remember that there are lots and lots of institutions and investors who buy and sell fixed income securities, including, most importantly, those issued by the Federal Government. When you hear the words yield curve, most people are referring to the chart of yields on Treasury obligations of different maturities. Here’s what that curve looks like under normal circumstances.

Chart courtesy of Winkipedia.

Note that the short-term T-Bills yielded about 2.5% whereas long-term obligations earned 4.5%. Sounds reasonable, doesn’t it? It was rational to all those buyers and sellers then too.

In fact, depending on the economy and the outlook for the future, the yield curve can look quite different from this “ideal.” The scale is different for the curves below, but here is what the curve looked like in January 2003.

Note that short-term rates are low but that was before the Fed started raising them. Now it’s July 2006 and this is what the yield-curve looks like! A lot different, isn’t it.

Lenders behavior and pricing operate the same way. They want to be compensated for that risk too, which is why, normally, the 30-year loan is the most expensive loan our industry offers. Usually 15-year loans are about .375% cheaper, 7-year hybrid ARM’s a little cheaper still, and then 5-year ARM’s, and so forth.

In fact, a key part of our strategy of helping people is to examine the pricing and correlate it with their risk sensitivity. In normal times, when the yield curve looks like that in the first graph, there is a lot of money to be saved if the borrower is in a position to take a 5/1 ARM instead of a 30-year fixed rate mortgage. If a borrower is only going to be in a home for 5 years, typical for first time homebuyers these days, why waste all that money on buying interest rate protection for 25 years when it’s not needed?

When the yield curve is flat like today, there isn’t much money at all to be saved with that strategy. If you are likely to be in a home for only 5 years, sure then it’s OK to save whatever you can, but other things being equal it strongly suggests getting that long-term fixed rate loan.

Of course, homebuyers today have been doing exactly the opposite!!!!!!! One statistic I saw was about Oakland, CA. In 2002 only 1% of the people took an Option ARM. That percentage had increased to 20% in 2004. Here’s the shocker! For the first half of 2006, the Option ARM’s market share there was 50%.

Buyers have been signing up for Option ARM’s, the most volatile product our industry offers, when the cost of long-term rate protection is REALLY CHEAP!!! Dumb!

All of those millions of people who have these kind of ARMs and the 3/1, 5/1, and 7/1 ARMs that are about to reset ought to be calling while long-term rates are a bargain. Sadly, they are not doing that. The mortgage industry is contracting, laying off people because the phones aren’t ringing.

That’s too bad. With the 10-year bond yield under 4.85 today, 30-year fixed rate loans are just a little bit over 6%. People ought to be jumping on that like a duck on a June Bug.

For a look at the Yield Curve plus well-presented recent data on all Treasury security yield charts click here.

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