(MONEY Magazine) – Bondsssszzzzzz.... Not exactly the most riveting investments. But that changed last January, if only briefly, when the media turned its klieg lights on the Treasury market. Why the sudden interest? Simple. For the first time since 1990, the yield on 30-year Treasury bonds dipped below the yield on two-year Treasury notes--or "inverted" in the parlance of bond traders.

Now, I realize that tracking the relationship between short- and long-term bond yields ranks on most people's List of Important Things to Do somewhere between reading the collected works of Kierkegaard in the original Danish and clearing out those softball-size dust balls behind the fridge. But among serious investors, the yield curve--a graph of Treasury security rates of every maturity from three months to 30 years (see the graphs at right)--merits serious attention. "The Treasury curve is sacred ground," says Ron Ryan, president of bond research firm Ryan Labs. "It's amazing how much is dependent on it."

Okay, so maybe Ron got a little carried away with that "sacred ground" stuff. But he's got a point. The rates on Treasury securities reflect everything from the Federal Reserve's moves to spur or rein in economic growth to investors' expectations about future inflation and interest rates, so this neat little curve packs a lot of valuable information. Most important for investors, it can provide insights into how the economy and the stock and bond markets might behave in the future. And getting access to the curve is a breeze. It appears nearly every weekday in the Money and Investing section of the Wall Street Journal and you can also see it daily on the Bloomberg Online website (www.bloomberg.com).

Before you can put the curve to use, however, you've got to know how to read it. Which brings us to the topic of this month's column: exploring the deep, dark mysteries of the yield curve (which, once you get the hang of it, are neither very deep nor dark).

The shape of things to come. Under normal conditions, the yield curve is a gently upward-sloping line showing yields on one-year Treasury bills one to two percentage points below the rates on 10- and 30-year bonds. Bond analysts and others who follow the yield curve cleverly refer to this configuration as a normal or positively shaped curve. And when you think about it, this shape makes perfect sense. The longer a bond's term, the greater the chance that its payments and its principal could be eroded by inflation or rising interest rates. So investors naturally demand higher yields for accepting the greater risk of longer- term bonds, which accounts for the rising slope of the curve. A normal yield curve indicates that investors expect healthy economic growth ahead without major moves in interest rates or inflation. And when the yield curve had this normal shape in June 1988, for example, investors' expectations were pretty much on target, as the economy expanded at an average quarterly pace of about 3.5% over the following year.

Often, though, the curve deviates from its normal configuration. Its arc can become much steeper, for example, when the Federal Reserve lowers the federal funds rate--the rate banks charge one another for overnight loans--in order to rev up economic growth. Since the Fed's actions have the greatest effect on the short end of the curve, short-term rates drop more than long-term ones, resulting in what economists refer to as a steep curve. When President Clinton was elected to office in November 1992, the yield curve was at one of its steepest points in modern history, with 30-year Treasury bonds yielding more than four percentage points above one-year T-bills. A steep curve usually presages a faster-growing economy--hardly a surprise, since lower short-term rates decrease companies' borrowing costs, making it easier for them to expand. And bingo, faster growth is just what we got in the wake of 1992's steep curve, as the economy bounded along at a 6% annual pace by the fourth quarter of 1993.

Occasionally, the curve twists itself into shapes that appear to defy the laws of economics and (not always the same thing) common sense. The most extreme case is an outright inversion--that is, when rates at the short end of the curve exceed those at the long end. In January 1981, the three-month and one-year T-bills yielded 15.3% and 14% respectively, while 30-year Treasuries yielded 12.3%. Why would anyone accept a lower rate for a 30-year bond than a three-month T-bill?

The answer lies in what the inverted curve is predicting about the future. Typically, an inversion occurs because the Fed has pushed up short-term interest rates to slow down the economy and choke off inflation, which back in early 1981 hit nearly 12%. (Long-term rates also go up in an inversion, just not as much as short rates.) "When the curve is inverted, investors are saying they think the Fed's actions will be successful," says American Century senior portfolio manager Bud Hoops. In other words, investors believe that inflation and long-term rates will drop in the future, which makes them anxious to lock in high long-term-bond yields while they can.

The Fed's strategy back in 1981 was successful--from certain points of view. Those high short-term rates plunged the economy into a deep recession that lasted from July 1981 through November 1982 and drove the unemployment rate to nearly 11%. As the economy sank, so did interest rates. Thirty-year bond yields dropped almost two percentage points by December 1982. An inverted curve preceding a recession is no fluke. A 1996 research paper by two economists at the New York Federal Reserve Bank concluded that the more inverted the curve, the more likely a recession was in the offing. Specifically, the Fed economists found that when the yield on three-month T-bills exceeds the yield on 10-year Treasuries by 1 1/2 percentage points or more, the odds are 70% or better that the economy will slip into recession within the next year.

And then there's the strange yield curve we've had recently, a humped curve, in which yields slope upward to the middle of the curve and then downward as you approach the long end, creating a camel-like hump. A humped curve often signals slower economic growth, which could very well be what it's saying today, since the Fed has increased the federal funds rate five times between June and March in an attempt to slow down the economy.

The question, though, is whether this humped curve, like some in the past, is a step on the way to a full-fledged inversion and a possible recession. Most analysts doubt that is the case. "The curve went hump-backed when Greenspan and the Treasury announced that they were going to buy back mainly longer-term bonds and reduce the supply of new long bonds," says Ryan. "I think what we're seeing at the long end is strictly related to supply and demand." In short, the low yields on 30-year Treasuries are the result of a dwindling supply, not a reflection of investors' expectations about inflation and interest rates.

Investments and the curve. As fascinating as this broad economic stuff is, I sense that what you really want to know is whether the curve can tell you anything about investing. The answer is yes, although I wouldn't want to suggest that the yield curve is always right or that you should be jumping in or out of stocks or bonds because of its shape. Rather, think of the curve as a signal of possible future trends in stock and bond returns. This useful information may help you fine-tune your overall investment strategy.

Stocks typically do better than long-term bonds with a normal yield curve, since an economy that's growing steadily, but not overheating, provides fertile ground for corporate earnings to blossom. In the year and a half after June 1988's normal curve, for example, the S&P 500 gained an annualized 22.9%, while long-term government bonds returned 15.4%. Bonds, on the other hand, tend to generate higher returns than stocks when the curve is steep. "That's probably because a steep curve often occurs when the Fed is trying to stimulate growth," says Sam Burns, an analyst at Ned Davis Research. "Inflation is usually low during these periods and the spread between long- and short-term rates is relatively high. So investors are getting a bigger premium for buying longer-term bonds." In the year following November 1992's steep curve, long-term government bonds returned more than twice as much as the S&P 500, 23.8% vs. 10%.

When the curve inverts, both stocks and bonds usually suffer. The rising short-term rates that trigger the inversion stifle economic activity--which is understandably bad for corporate earnings and stock prices--and also make investments like money-market funds more competitive with stocks. In the 18 months following January 1981's inverted curve, for instance, the S&P 500 lost 10.3%. But if the inversion signals a recession and you buy long-term bonds just before rates drop, you can make a killing. Anyone who bought 30-year Treasuries in January 1981 earned more than an annualized 17% over the next five years.

Reading today's humped curve is trickier. Usually a flat or humped shape is a negative for stocks and, at least initially, bonds because the Fed is jacking up short-term rates to dampen economic growth. And except for seemingly immune tech shares, stocks indeed slumped the first few months of this year. Aside from 30-year Treasuries, whose yields have fallen, bonds were largely mediocre performers too. If the Fed's rate hikes can slow the economy without sinking it, the curve could morph into a normal shape, which would be good for stocks. On the other hand, if the Fed keeps driving rates up and up, we could get a true inversion--which would be bad for stocks and bonds--although analysts don't consider this scenario much of a possibility.

Yield curve forever? Some curve watchers are concerned that the buybacks of older long-term bonds and the possibility of fewer 30-year bonds being issued in the future could, so to speak, throw a curve at the yield curve, making it less useful as both a pricing mechanism for bonds and as a predictive tool. But I think it's too early to tell whether things will go that far. So unless we get proof that this reliable indicator has been relegated to the trash heap of history, my advice is "Keep your eyes on that curve!"

Senior editor Walter Updegrave is the author of Investing for the Financially Challenged (Warner Books). You can reach him at investing101@moneymail.com.