Will CD rates get twisted?
October 11, 2011
The Federal Reserve's Operation Twist is designed to bring down longer-term interest rates. Will this take away the advantage of long-term CDs?
Looking at the numbers suggests that Operation Twist might be the least of the worries surrounding CD rates--and there is already enough to worry about.
Interest rate theory and practice
By way of background, the normal state of affairs is for longer-term interest rates to be higher than shorter-term ones. This compensates you for the greater risk of changes to inflation or of default as you wait longer to get your money back. However, long-term rates can sink to level of short-term ones, or even lower on rare occasions, if the market anticipates low interest rate conditions in the future. This can happen when there is an outlook for a slow economy or falling inflation.
In Operation Twist, the Federal Reserve is actively trying to bring long-term rates down closer to the level of short-term rates, by increasing the demand for long-term securities. This will take place in the U.S. Treasury bond market, leaving CD depositors to wonder whether the effect will carry over to interest rates on CDs.
CD rates vs. Treasury rates: Good news and bad news
Comparing the interest rates on CDs and Treasuries over the past couple years suggests that long-term CD depositors don't necessarily have to worry about Operation Twist, but that's partly because the advantage of long-term CD rates has already eroded. Here's the good news and bad news:
- The good news is that CD rates can move independently from Treasury rates. Looking at CD rates and Treasury yields over the past two years makes it clear that while the two may be somewhat related, they are perfectly capable of moving independently from one another. Two years ago, five-year CD rates and five-year Treasury yields were very similar, with CD rates at 2.23 percent and Treasuries at 2.28 percent. Over the next year, Treasury yields fell by just over a full percentage point, while CD rates fell by half of that. Over the past year, though, five-year CD rates have had the greater fall, dropping by 0.41 percent, compared to 0.31 percent for five-year Treasuries. In summary, then, over the past two years Treasury yields were quicker to fall, and have fallen farther overall.
- The bad news is that long-term CD rates have been losing their advantage all on their own. CD rates may not be in lockstep with Treasury yields, but they've still arrived at a similar place. Not only are both now lower, but five-year CD rates and Treasury yields have also lost much of their advantage over shorter-term interest rates. In the case of CDs, in early October 2009, five-year CD rates were 1.97 percent higher than one-month CD rates. By early October of 2011, that advantage had dropped to 1.19 percent.
In short, CD depositors don't have to worry too much about Operation Twist bringing down long-term interest rates, because long-term interest rates are already low. That's one of the curious things about Operation Twist. Even so, CD depositors should hope the Fed's maneuver is successful, because a stronger economy would be the best medicine for both short and long-term CD rates.
