Interest rates are currently inverted, a market situation in which the longer you commit to lending your money, the less your return on investment. It’s counter-intuitive so let’s delve a little deeper.
Imagine if a friend asked you to borrow money for two years and you charged him interest on that money. There are some risks in lending:
- The risk of not getting paid back
- The risk that the money could have earned more for you somewhere else
- The risk that the value of the dollar will be lower when you get your money back
The more risk you take, the higher the interest rate you should expect on your money. This is Risk versus Return at its finest. So, if that same friend wanted the money for 10 years instead of two years, you would expect a higher return because your risk is higher on all of the points above.
- He could lose his ability to repay you in those 10 years
- You could have had countless other investment opportunities over those 10 years
- The value of the dollar could swing wildly in those 10 years
In an inverted yield curve scenario, the 10 year program actually pays less than the two year. The theoretical risk is much, much higher over 10 years, but the "reward" is lower.
The inverted yield curve is one of the big reasons why today’s short-term ARM and long-term fixed mortgage rates show very little difference.
