Understanding Yield Curve Changes
By: Jeff Brown

As world records go, the steepest yield curve in history isn’t as easy to grasp as the world’s fastest human or the most home runs in a season. But the yield-curve record set the other day may have a bigger effect on us ordinary folk, as it influences borrowing costs and interest earnings, and may signal good times ahead.

The Financial Times reported that the difference between yields on two- and 10-year Treasury securities briefly surpassed 2.76 percentage points, or 276 basis points, after the Federal Reserve announced Dec. 16 that it would keep short-term rates low even though the economy was improving.

The 276 basis point “spread” beat the previous record of 274 basis points set in August 2003, the Financial Times said.

By the end of the week, the spread was just a smidgeon lower, at 275 basis points, with the two-year Treasury note yielding 0.8% and the 10-year bond 3.55%. A year ago, with the nation in the grips of the financial crisis, the spread was only about 140basis points, largely because 10-year Treasuries were yielding a mere 2%.

Plotted on a graph, various Treasury yields create a “steep” curve when rates are low on the left and higher on the right. At other times, the curve is “flat” – short- and long-term interest rates are about the same. Occasionally the curve is “inverted” – short-term rates are higher than long-term ones.

While not all experts interpret the various curves the same way, a steep curve like today’s is widely thought to portend good times.

The Fed has kept short-term rates low to make it easier to borrow money, which should stimulate the economy. But the Fed does not have as much influence over long-term rates. Those are set by supply and demand as investors trade bonds, and are influenced in part by what investors expect short-term rates to be in the future. Higher long-term rates mean investors think the economy will perk up enough that the Fed will have to raise rates to curb inflation.

A steep yield curve can be profitable for lenders. They can borrow at low short-term rates and lend at the higher long-term rates, profiting on the difference.

For investors, a steep yield curve means earnings are very low in short-term holdings. According to the BankingMyWay.com survey, the average money market account pays just 0.369%, while a three-month certificate of deposit yields only 0.4%.

It is tempting to tie money up for longer to earn more. Five-year CDs average 2.19% and those 10-year Treasuries pay 3.55%. A 30-year Treasury earns 4.45%.

But although the difference between these short- and long-term holdings is unusually large, even the long-term yields are fairly low by historical standards. Two-year Treasuries paid 5% as recently as 18 months ago.

For now, it may be best to live with low short-term yields so you can get at your money to reinvest if rates go up next year. Of course, even if you go with bank savings, it pays to use the BankingMyWay Search Tool to find the best deal.

While the average six-month CD pays just 0.618%, Discover Bank (Stock Quote: DFS) has one at 1% and AIG Bank (Stock Quote: AIG) does even better, at 1.39%. Also, keep an eye out for market-beating deals at any credit union you are eligible to use.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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