(MONEY Magazine) – AT THE BOTTOM OF THIS page is a modest little graph that could make you a smarter investor. It is known as the yield curve and, despite the name, it has nothing to do with merging traffic or bends in the highway. It is, however, a road sign of sorts--one that can be an excellent predictor of the economy and, by extension, the stock and bond markets. This particular graph, for example, based on data as of Jan. 12, is hinting that market pessimists today are wrong--that the economy will continue growing slowly and that lower interest rates lie ahead. More on that later.

The yield curve charts the differences in yield among U.S. Treasury securities at every maturity from three months (at the left end of the curve) to 30 years (the right-end point). What gives this information its Rosetta stone quality is the insight it offers into the forces at work in the Treasury market. And since corporate and municipal bond investors and commercial lenders all use Treasuries as benchmarks, whatever happens in that market ripples into virtually every corner of the economy. As a result, says James M. Benham, chairman of the Benham mutual fund group: "The yield curve not only helps you know what bonds to buy and sell, it also signals what is likely to happen in the economy."

In normal circumstances, fixed-income investors demand (and get) a higher yield for bonds with longer maturities. You know instinctively that the risk that inflation will erode your investment increases with time. So does the possibility that rising interest rates could depress the value of your bonds. You want to get a higher yield for going out longer. That's why most of the time the yield curve slants upward to the right--what economists call a "positive" slope.

But the relationship between short and long maturities changes a bit with every day's bond trading. Expectations about inflation, forecasts of economic growth or slowdown, rumors about Federal Reserve policy or deadlocked negotiations over the budget can all affect the arc of the curve. For example, if investors expect the Fed to rein in the economy by raising overnight interest rates, investors might push up short-term interest rates in anticipation. Then the yield curve would flatten as short-term rates rose but long-term rates did not. Or if the federal budget deficit were to jump sharply, the market would push up long-term rates, fearing that financing the deficit would result in an oversupply of long-term bonds. Since short-term rates would react less to such news, the yield curve would steepen.

The yield curve's predictive powers are strongest when the curve is at its extremes. For instance, in the rare cases when the arc becomes inverted--with at least some short-term rates higher than long-term--economic trouble usually lies ahead. How so? Banks and other financial institutions cannot lend at a profit when the rate they have to pay depositors approaches what they can charge borrowers. Thus when the curve is inverted, housing and business loans contract sharply and recession is not far behind. Benham notes that since 1960 there have been seven yield-curve inversions and only once did a recession fail to follow within nine to 12 months. For example, the inversion of the yield curve that began in early 1981 (and continued through the October 1981 example shown in our chart at the top of this page) anticipated the painful recession that started in July 1981 and lasted until November 1982.

By contrast, a sharply positive curve is usually a harbinger of economic growth. (In such a curve, the difference between two-year and 10-year yields comes to 1.5 percentage points or more.) A wide spread between the short-term rates paid depositors and the long-term rates charged to borrowers means that banks can lend profitably and fuel economic growth. For example, the November 1991 curve shown directly above signaled a continuation of the expansion that began in March 1991 and is still going on.

When the curve reaches extremes like these, smart investors look for opportunities. For example, when the curve inverts, it's time to enjoy the high yields at the short-term end of the curve. But you also need to watch for signs of recession--such as slowdowns in mortgage and commercial lending and increases in unemployment. That's your signal to move some money into 10-year or longer bonds (or into mutual funds that buy them). The reason: As loan demand tapers off in a recession, interest rates are likely to fall across the board. When that happens, longer-term bonds will get a much bigger boost in price than short-term. Investors who bought 10-year bonds in October '81, for example, raked in total returns of 50.3% by the end of 1982.

Conversely, when the curve is angled very positively and the economy is humming, be alert to warnings that the good times for long bonds are over. Continuing economic growth, while a positive for the stock market, tends to spark inflation fears, which cause long-term-bond yields to rise and prices to fall. So when the curve is steep, keep an ear to the ground for hints of higher inflation or speculation the Fed plans to raise short-term rates. When the rumors start, you'll have minimal capital losses if you shift 50% or so of your fixed-income money into money-market funds or three-month Treasury bills.

So what should you make of today's curve? It's relatively flat, with 10-year Treasuries yielding only one point more than the two-year variety. That suggests GDP will keep growing, but even more slowly than last year's anemic 2%. Says David Jones, chief economist at Aubrey G. Lanston, a New York City dealer in government securities: "The curve is flat because long-term rates have come down more than short-term rates. But that's a positive signal that the market expects the central bank to keep reducing short-term rates to stimulate growth." Jones notes that once the Fed has acted to raise or lower rates, it typically makes three to four more moves in the same direction.

If you buy Jones' prediction of slow growth and lower interest rates (which incidentally is shared by MONEY's Wall Street editor Michael Sivy), you should stick with maturities of five years or longer in your fixed-income investing. As for stocks, the weaker economy that will help bond prices will hurt company profits, and Sivy expects a 10% to 15% drop in the stock market before year-end.

If you're not sure you want to spend your time following the yield curve and shifting your investments around accordingly, you have an alternative. Simply keep your money in five-year Treasuries. A 1994 study by the money-management firm Dimensional Fund Advisers found that over the long run, five-year Treasury issues provide the optimum mix of highest total return with the least risk. Shorter-term Treasuries can't match the return, while longer issues are much riskier. But if you want the edge that comes from tracking one of the most reliable economic indicators, keep an eye on that curve.