Interest rates are a mystery to most these days, even experts — a sentiment well demonstrated in the clever Ally Bank ad featuring Nobel prize winning economist, Thomas Sargent. In what appears to be a grand theater, Sargent sits on stage, under a spotlight, in front of a quietly captivated audience. He is then asked from stage left, “Professor Sargent, can you tell me what CD rates will be in two years?”
“No.” He states matter of factly to a still, silent room. Ah, why if one of the best economists in the world can’t tell us what CD rates will be, no one can.
But what if I told you he was lying?
To be fair, Mr. Sargent isn’t really lying per se, as no one can predict exactly what CD interest rates will be years from now, down to the percent. However, he’s certainly not telling the whole truth, because based on today’s CD rates, we can make a pretty darn educated guess as to what they will be in the future — and how that will relate to the future of the U.S. economy as a whole.
How Current CD Rates Are Set
Knowing how financial institutions set their interest rates on CDs will help you understand what changes to rates they expect to happen down the line.
Interest rates on short-term CDs, as well as other short-term savings vehicles like savings and money market accounts, closely follow the Federal Funds Target Rate. This is the interest rate, set by the Fed, at which banks that are part of the Federal Reserve system may borrow from each other in order to meet reserve requirements. While the actual interest rate changes daily, the target rate was set to remain between 0.00% and 0.25% in December 2008 and will remain so through 2015 at the earliest.
Not surprisingly, then, the FDIC reports that the average 6-month CD rate this week is just 0.15%, while the average 12-month CD rate is 0.24% — just within the Fed’s target rate.
Other factors that affect CD rates include demand for loans, inflation, competition among financial institutions and general investor sentiment regarding the riskiness of the market.
Of course, when considering longer-term CD rates, it becomes more difficult for banks to project how they should be set. If a long-term CD rate is too low, bank customers won’t want to deposit their money. If it’s too high, the institution risks losing money. So to make fairly accurate predictions, banks reference the returns on comparable investments to set their long-term CD rates — namely, U.S. Treasury yields.
CD Rates Today and the Future of the U.S. Economy
Because we know that the Fed’s rate is used to set short-term CD rates, we can infer that today’s CD interest rates will remain about the same through 2015, as the Fed has stated it will keep the target rate at near-zero until then. But what about long-term CD rates?
Calculating Long-Term CD Rates
As mentioned above, the average 12-month CD rate, according to the FDIC, is a paltry 0.24%. The average two-year CD rate is not much higher at 0.39%.
If a depositor secured a two-year CD at 0.39% annually, the total return over two years would roughly total 0.78%. On the other hand, in order to realize that same return by investing in one 12-month CD, followed by another 12-month CD after the first matures, that depositor would need to earn 0.54% in the second year. Based on that math, there is the implication that we could see CD rates rise by about half a percent next year. Using the same calculations, you can estimate what CD rates might be in four or five years as well.
Rates will continue to fall.
It’s important to note, though, that these calculations are also based on the assumption that rates will, in fact, go up. In addition to the expectation that depositors are paid a higher interest rate in reward for committing to a longer deposit period, Barrington explains that “long-term CD rates are generally higher because of the expectation — or at least the possibility — that rates will be higher in the future.”
However, you may notice that some institutions are currently offering flat rates across all CD terms, or even better rates on their short-term CDs than long-term — a sign that banks aren’t optimistic about the future. If many banks are offering lower rates on long-term CDs, it’s a sign that the marketplace is betting on rates dropping further.
Demand for loans will be low.
Financial institutions make much of their revenue from interest earned through lending, and the more money that is on deposit, the more money that’s available to lend. However, if there is no demand on behalf of consumers and businesses for loans, there is no incentive for banks and credit unions to provide attractive rates — otherwise, they would simply accumulate deposits to sit around, unused.
Since long-term CD rates are quite low, it’s a sign that banks don’t expect that demand for loans to increase any time in the near future, and therefore, do not see a need to encourage deposits.
Investors will remain timid.
In what is often referred to as a “flight to safety,” investors spooked by the financial crisis in 2008 removed their money from risky market securities and put it in relatively safe investments like U.S. Treasuries. Of course, the more money that’s pumped into bonds, the lower their yields are driven (today’s 10-year Treasury yield sits at 1.76%).
Because long-term CD rates are heavily based on Treasury yields, we know that they can’t recover much until bond yields do — and the only way that can happen is if investors regain confidence in the market and invest more heavily in higher-risk options. Based on current yields, that hasn’t happened yet, and probably won’t for a while.
So what does this mean for today’s depositors? Basically, don’t look to CDs or similar low-risk investments as anything but; we know that the lower the risk the lower the reward, so investors concerned with earning a high return should invest in securities that can deliver one (i.e., market-based investments), understanding that some risk must be involved.
For those who are most concerned with safely preserving cash, that’s where a CD can help — but stick with short-term accounts. It’s important not to mix the two objectives, and avoid locking funds into extremely long-term CDs in an effort to chase subpar interest rates.