If you own bank stocks, high-yield bonds or a home with a big adjustable-rate mortgage, the bond market may have bad news for you.

In recent weeks, professional investors and economists have been carefully tracking the difference between yields on short-term and long-term Treasury notes. Historically, the difference is usually big, about three-quarters of a point, signaling that investors expect solid economic growth and consequently demand higher long-term returns. Recently, the difference between yields on short-term and long-term Treasury notes has all but disappeared, which could mean trouble for the economy.

Some economists and analysts predict that the Federal Reserve's efforts to curb inflation by raising short-term interest rates soon could push them above long-term rates, a phenomenon known as an inverted yield curve. The development often -- but not always -- presages an economic downturn. The narrowing or flattening of the curve is generating concern on Wall Street and could be painful for small investors.

In late trading Wednesday, the gap in yield between two-year and 10-year Treasury notes -- one measure of the yield curve -- stood at about 0.08 percentage point, down from about 0.30 percentage point in September soon after Hurricane Katrina hit the Gulf Coast and well below the historical average of 0.75 percentage point.

Here's why the current flattening of the yield curve matters for investors and consumers. Even as long-term rates remain little changed, short-term rates are rising. As a result, any financial company that borrows at short-term rates and lends at longer-term rates is seeing its profit margins squeezed because of the narrow yield spreads.

In addition, homeowners whose adjustable-rate mortgages or home-equity lines of credit that key off short-term rates are facing higher monthly payments, leaving them with less money for things like vacations and new cars. If homeowners and others curtail spending, some financially shaky companies are apt to get in trouble, meaning their bonds and stocks will suffer, and so will investors.

Granted, many economists -- including outgoing Federal Reserve Chairman Alan Greenspan -- say that if the yield curve inverts, it need not end what has been the most stable stretch of economic growth in U.S. history. One reason for optimism: Interest rates remain at relatively low levels, so money for investment and growth still is cheap to obtain.

For those who share the bond market's sense of gloom, cash investments such as bank deposits and money-market funds offer some consolation, because their returns rise with short-term interest rates. Professionals also recommend sticking to defensive stocks, or those that perform well even in a slow economy, such as consumer staples and health care. For home buyers and those with adjustable-rate mortgages that soon will reset, experts generally suggest locking in longer-term fixed rates.

Here is how the unusual situation in the bond market will affect the holdings of individuals in different areas.

These days, many cash instruments, which are tied to short-term rates, offer yields approaching 4 percent. That is almost as much as the yield on long-term bonds without the risk of tying up money for an extended period. The average money-market mutual fund, which holds short-term Treasury securities and commercial paper, or short-term corporate IOUs, yielded 3.38 percent this week, for example, after hitting a low of 0.50 percent two years ago, according to iMoneyNet Inc., a Westborough, Mass., research firm.

Banks such as HSBC Holdings PLC's U.S. arm and New York-based Emigrant Savings Bank's EmigrantDirect offer up to about 4 percent yields on online savings accounts. The average yield on a one-year certificate of deposit reached 3.19 percent this week, and for a six-month CD was 2.71 percent, according to Bankrate.com. Even yields on typical savings accounts at the nation's biggest banks and thrifts have risen to an average 0.53 percent from 0.41 percent a year ago, according to Bankrate.com. Such rates all bump up the appeal of cash and other short-term holdings right now.

For bond investors, some strategists recommend funds that offer shorter duration investments, such as less than a year, whose yields have risen in line with Fed rate increases. Schwab's YieldPlus Ultra-Short Bond Fund returned 3.11 percent last year, with annual operating expenses of 0.44 percent. PIMCO offers several shorter duration options, including its Short-Term Fund, which returned 1.77 percent in the past year with expenses of 0.75 percent. (A Treasury yield-curve chart appears daily on C2.)

A flat yield curve generally is bad news for stock investors, as it typically presages economic slowdown and smaller corporate profits. Keith Wirtz, president and chief investment officer at Fifth Third Asset Management, recommends sectors that can withstand an economic slowdown, including consumer staples, such as PepsiCo and Procter & Gamble, and health care, such as Medtronic and Teva Pharmaceutical Industries.

Among those likely to be hurt are banks, which borrow at short-term rates and lend at long-term rates, profiting from the difference. Rick Jones, manager of the BB&T Large Company Value Fund, is leaning away from community banks, which often depend on this spread income. He favors stocks like Northern Trust and Bank of New York, which rely more heavily on asset-management and securities-processing fees.

Some analysts also say stocks of home builders and major mortgage lenders are less attractive, as the Fed raises rates in part to cool the housing market.

Not all strategists believe the flat yield curve is necessarily bad for stocks. Part of the reason: Long-term rates still are relatively low. James W. Paulsen, chief investment strategist at Wells Capital Management, suggests investors not abandon economically-sensitive stocks until the yield on the 10-year bond rises to around 5.5 percent-6 percent, up from about 4.5 percent currently.

For homeowners and home buyers, the flatter yield curve means adjustable-rate mortgages are looking less and less like a bargain. ARMs currently account for 32.9 percent of mortgage applications, down from 36.6 percent in March, according to the Mortgage Bankers Association. The flatter yield curve is "going to move you to a fixed-rate environment," says Doug Duncan, the MBA's chief economist.

For many borrowers, the savings from an adjustable may no longer be worth the risk that rates will rise further. Rates on one-year adjustables, for instance, currently average 5.48 percent, according to HSH Associates in Pompton Plains, N.J. That is just 1.01 percentage points less than average rate on a 30-year fixed-rate mortgage. Worse yet, even if interest rates remain unchanged, a borrower with a one-year ARM would see the rate on their loan jump to 7.1 percent after 12 months, according to HSH. That is because one-year ARMs typically carry low introductory rates.

While fixed-rate mortgages remain attractive by historical standards, borrowers looking to keep their monthly payments down are running out of good choices. Some borrowers may consider riskier products such as option ARMs and interest-only mortgages, which offer lower initial rates, but much higher terms later.

Interest in 40-year mortgages also could increase, says Dale Westhoff, a senior managing director at Bear Stearns. Such loans currently account for less than 2 percent of all mortgages, though an increasing number of lenders are making these available. Forty-year mortgages enable borrowers to lower their monthly payments by spreading the payments over a longer period of time, but they can be costly over the long run. Rates on 40-year mortgages tend to be about 0.25 to 0.375 percentage point higher than the rate on a comparable 30-year loan. Borrowers also can pay more interest over time, because the loan is stretched over an additional 10 years.

Long and Short

The flattening yield curve -- when the gap between short-term and long- term rates narrows -- is generally bad news for small investors. Here's why:

It often signals an economic slowdown, which can lead to lower corporate profits and a stock-market decline.

If the economy contracts, corporate bonds could also suffer, especially riskier high-yield issues.

For conservative investors who prefer to keep their money in cash, though, rates are close to long-term bond yields.