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Making the curve: CD rate curves can help you make good financial decisions

May 23, 2011

| MoneyRates.com Senior Financial Analyst, CFA

Tired of low CD rates?

It may seem like there is nothing new in the CD marketplace, as interest rates on CDs have stayed stubbornly low for the past couple of years now. However, there is some action in this market, as the relationship among short, medium, and long-term CDs is constantly changing.

In a friendlier environment for CD depositors, you might be able to point to a clear surge in rates as an opportunity. In today's market, you have to look for more subtle signs, such as how CD rates have changed relative to one another, in order to spot opportunities.

CD rates: riding the curve

A range of bond yields from long to short is commonly called a yield curve. The normal shape of that curve is such that long-term yields are higher than short-term ones, but this generally does not happen in a straight line - hence the word "curve." The steepness of the yield curve, and where the bends or kinks in the curve occur, are closely analyzed by bond analysts looking for opportunity.

You can look at CD rates the same way. Sure, you are generally going to find higher rates associated with longer-term CDs, but how those rates are changing relative to one another can give you some clues as to which interest rates on CDs are becoming better or worse deals relative to other CD rates.

Consider 1-year, 3-year, and 5-year CD rates. As you might expect, 5-year CD rates are higher than 3-year rates, which in turn are higher than 1-year rates, according to national averages posted by the FDIC as of late April. Twelve months ago, that same basic fact was also true. However, while long-term CDs have maintained the highest rates, the relationship among the different rates has changed.

For example, as of late April, average 3-year rates were 58 basis points higher than average 1-year rates, and average 5-year rates were in turn 58 basis points higher than average 3-year rates. That's a very neat, symmetrical relationship, which was not always the case. A year earlier, in late April of 2010, 3-year CD rates enjoyed a 79 basis point advantage over 1-year rates, while 5-year rates were only 53 basis points ahead of 3-year rates.

Overall, 1-year CD rates have held up best over the past year, falling by only 30 basis points. 3-year rates have fallen by 51 basis points, while 5-year rates have fallen by 46. In short, if you go back to thinking of these relationships as part of a yield curve, that curve has sagged in the middle over the past year, which might influence you away from medium-term CDs.

Other considerations in choosing CD rates

Of course, there are other considerations in choosing CD rates, such as the relative benefits of short-term liquidity and long-term rate stability, as well as the changing role of inflation. However, weighing these trade-offs makes having some sense of relative changes in the yield curve more valuable.

After all, if these other trade-offs didn't exist, you'd simply grab the highest rate available. However, since rates have to be weighed against other factors, knowing which rates are becoming relatively more - or less - attractive can help you with these more complex judgments.

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