As the debate between bulls and bears continues over where interest rates are headed, it's important to note that this market uncertainty has spurred both sides into the bond market.

The bulls, who believe the

Fed

will lower rates, have been buying short-term securities and thus pushing the yield lower. The bears, who expect rates to rise, have been selling the 10-year note and driving its yields higher.

In our graph below, the yield curve has finally reverted to its more normal condition of sloping upward. (Price and yield move inversely -- when prices rise yields fall and vise versa.)

The key point is that the 10-year yield is higher than any of the other maturities across the spectrum -- and this was not always the case. Since August 2006, the curve has been inverted so that the two-year yield is higher than the 10-year yield.

This reversion back to an upward slope is a positive for the market as it reinstates certain economic theories on how the term structure of interest rates should be determined.

If we assume that in late 2007, an economic slowdown in the U.S. will prompt the Fed to bail out the economy, then investors should play the short end of the yield curve. By short end, I mean the two-year or less "Time to Maturity" spectrum of securities.

If the Fed drops rates, then it is the short end of the curve that will benefit as prices of these securities will rise, thus lowering yields to reflect the new lower interest rate environment. That is what the bulls are doing -- they are taking positions in these short-term securities now in anticipation of a rally in short-term Treasury prices as a result of any Fed easing.

For this to happen, however, the Federal Reserve may have to see significant evidence of a slowdown and then cut rates by 50 basis points, rather than the incremental 25 basis point steps it has favored in the past. And the U.S. economy likely would be in real trouble for that to happen.

US Treasury Composite Yield Curve

Click here for larger image.

Source: Bloomberg
Date: 4/18/2007

If you subscribe to the view of rates having to be lowered, then below are some funds focused on the short end of the spectrum that may prove to be good investments to get into. As usual, investors should make decisions in line with their willingness and ability to assume risk.

Below I have included the entire yield curve so investors can take a look at the complete spectrum of Treasuries securities and their related yields. Some of the funds mentioned above are exposed to the very short-term maturities (1 month to 1 year), which will also benefit in terms of price appreciation should interest rates fall.

US Treasury Composite Yield Curve

Click here for larger image.

Source: Bloomberg
Date: 4/18/2007

Sam Patel, CFA, is the manager of mutual fund research for the TheStreet.com Ratings.

In keeping with TSC's Investment Policy, employees of TheStreet.com Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Patel cannot provide investment advice or recommendations, he appreciates your feedback;

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