Personal Finance Blog By MoneyRates

How higher inflation might benefit savings accounts -- eventually

April 17, 2014

| Senior Financial Analyst, CFA

The Bureau of Labor Statistics (BLS) announced Tuesday that inflation perked up a little bit in March -- and the stock market promptly rallied after the announcement.

To anyone who lived through the inflation-plagued 1970s, the idea of investors welcoming inflation may seem like a through-the-looking-glass type of experience. Welcome to the 21st century.

The upside of rising prices

The BLS reported that the Consumer Price Index rose to 0.2 percent in March. That would project to an annual inflation rate of 2.4 percent -- higher than the 1.5 percent rate of inflation over the past year, and only the second time in the last eight months that inflation exceeded 0.1 percent.

Significantly, the BLS report showed solid price gains across most sectors, rather than inflation being narrowly driven by a spike in one or two sectors. That seems to suggest these price increases are not due to temporary disruptions, but that they are taking hold throughout the economy in general.

Here's the tricky part: Inflation is not normally welcomed like a long-lost friend. So why the positive market reaction to an uptick in inflation?

The answer is that while moderate inflation is good, if it slips toward deflation (i.e., falling prices), it is a symptom of severe economic weakness. In fact, deflation can become part of a vicious cycle: Low demand leads to falling prices, and once consumers observe that prices are falling, they feel no urgency to buy now, so demand falls further.

From Wall Street to the Federal Reserve, there has been some concern that inflation, which has been at 1.5 percent over the past 24 months, has been a little too quiet. After all, if the economy were actually picking up steam, one would expect inflation to be rising a bit.

Thus, signs of life from inflation can be interpreted as signs of life for the economy as a whole.

Careful what you wish for

However, the experience of the 1970s can be seen as a cautionary tale. That was the decade when the expression "stagflation" came into the vocabulary -- a combination of economic stagnation and high inflation. The 1970s proved that rising inflation does not necessary signal strengthening economic demand.

Still, two things warrant the positive reaction to a rise in inflation this time around. First of all, increasing from a 1.5 percent to a 2.4 percent annual rate is hardly a sign of runaway inflation. Second, this comes in the context of the most recent employment report, which showed 192,000 new jobs being created in March. This suggests that there just might be an actual increase in economic activity accompanying the rise in inflation.

That might seem like cold comfort to depositors in savings accounts, who have already seen their interest rates fall behind the inflation rate. What savers should hope to see is a sustained strengthening of economic growth accompanied by only a moderate rise in inflation, as those are the conditions under which savings account rates might finally get ahead of rising prices.

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Why you shouldn't stress over bank stress tests

April 3, 2014

| Senior Financial Analyst, CFA

In the latest round of stress tests conducted on 30 major U.S. banks, the Federal Reserve gave a thumbs down to the capital plans of five of those banks. But those failures can actually be seen as a positive sign for U.S. bank customers.

Overall, the exercise bodes well for the stability of the U.S. banking system, which should not only cheer up anyone with savings accounts or other money on deposit with a U.S. bank, but should also be a relief to taxpayers in general.

Stress test results

Two different types of stress tests were conducted recently:

  1. A Dodd-Frank Act Stress Test (DFAST). This is a fairly traditional type of bank funding test, looking at the amount of capital currently on hand to meet obligations. Twenty-nine of 30 banks passed this test.
  2. A Comprehensive Capital Analysis and Review (CCAR). This is more of a forward-looking type of stress test, in that it anticipates the sufficiency of capital in the context of the bank's plans to use capital for things like shareholder dividends or share buyback programs. Twenty-five of 30 banks passed this test.

Those banks that failed these tests are now required to come up with plans for putting their capital structures and strategies in shape to pass muster.

The upside of failure

Given the size of these institutions, it may seem alarming that the Federal Reserve rejected the capital plans of five of them. However, the stress test results were a positive sign in some respects:

  1. The idea is to catch problems before they lead to a crisis. As nice as it might seem if all the banks involved passed with flying colors, there is something reassuring about the fact that these tests actually identified some problems. This is in contrast to the simmering problems that were routinely overlooked before the 2008 financial crisis.
  2. The CCAR test represents a higher standard. By looking at how a bank's planned use of capital will play out, regulators are recognizing that bank finances are dynamic rather than static.
  3. Most problems with the CCAR test have ready fixes. Failure is not a kiss of death for the banks involved, but it will force them to come up with safer strategies.
  4. Stress tests tend to reinforce the value of deposits. In recent years, banks have had little trouble attracting money into savings accounts and other deposits, which is one reason why bank rates are so low. Should lending volume pick up, deposits will help provide liquidity, which could encourage banks to start to raise deposit rates.

The bottom line is that stress tests in banking perform much the same function that a cardiologist's stress tests do: They aim to identify potential problems under controlled conditions, so those problems do not spring up unpredictably. While it is unfortunate that any problems were found, it is always better to know about such problems than to be taken by surprise.

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Why long-term rates have gone flat -- again

March 20, 2014

| Senior Financial Analyst, CFA

When long-term interest rates reversed course dramatically last year and started rising, it was natural to think it was just the beginning of a long-term trend. Now, that rise is starting to look more like a one-time shift to a new reality.

That could be good news for the housing market, but not such good news for savings accounts.

A rise and a rest

The bond market is a good barometer for changes in the interest rate environment, because freely traded securities can adjust to new developments almost immediately.

From mid-April to mid-August of last year, 10-year bond yields rose by about a full percentage point, reaching 2.73 percent by August 16. It looked like the beginning of a trend, but as of March 14 of this year, those bond yields were at virtually the same level. Thirty-year mortgage rates have followed a similar trajectory, rising sharply from early May to early July, and then essentially leveling off since.

A time to wait and see

Why did these steep climbs in rates suddenly stall? It seems as though the market has gone into a wait-and-see mode, for a number of reasons:

  1. The economy appeared to lose momentum late in 2013.
  2. A harsh winter made it unclear to what extent the economy's sluggishness was merely seasonal.
  3. With the Fed tapering its quantitative easing in baby steps, the impact is still unknown.
  4. The Ukrainian situation threw a new wild card into the mix.

A big reason interest rates are in no hurry to go anywhere is that inflation has remained firmly in check. On March 18, the Bureau of Labor Statistics reported that the Consumer Price Index rose by just 0.1 percent during February. That is consistent with the low level of inflation over the past year, at just 1.1 percent.

Even with current mortgage rates at just above 4 percent, mortgage lenders still have room to profit if inflation is going to be down around 1 percent. While up from a year ago, today's mortgage rates are still extremely attractive compared to their historical levels.

Keeping a lid on short rates

Long rates were the first to rise because by nature, as they have to anticipate the long-term. Short-term rates, which include rates on savings accounts, money market accounts and most certificates of deposit, are able to adjust frequently, and thus can afford to react rather than anticipate.

This is why rates on savings accounts have stayed anchored near zero. Until either stronger growth or rising inflation become evident, savings account rates will have no reason to go anywhere. Fed policy only reinforces this heavier weight on short-term rates. The Fed has clearly signaled that it plans to allow long-term rates to rise before adjusting its policy toward short-term rates.

This means now is actually a good time to shop for short-term rates. If the market is not moving, the only way to get a better rate is to do it yourself.

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Economic consequences of the Ukrainian crisis

March 6, 2014

| Senior Financial Analyst, CFA

It is difficult to write about the developing situation in the Ukraine while the wheel is still very much in spin, but no event so far this year threatens to have as big an impact on the economy and investments as Vladimir Putin's attempt to exert control over his smaller neighbor.

As things stand now, Putin seems to have backed off incursions into the Ukraine beyond the Crimean region. The latter remains under his effective control, however, and seems headed toward breaking away from the rest of the Ukraine as either a separate, Russian-aligned state or part of Russia itself.

Economic implications

Unless there is some dramatic, peaceful reversal of the situation, here are some possible economic outcomes:

  1. A drag on global growth. The European Union and the U.S. are threatening economic sanctions against Russia, and Russia is threatening economic retaliation. That typically means slower growth all round.
  2. The specter of inflation. Russia already has made a habit of using its gas exports to Europe as economic blackmail. Ramping up that tactic would be inflationary, and oil supplies could also come into play if the conflict escalates.
  3. Other storm clouds. China has long threatened to act on its territorial disputes with Japan and Taiwan. If Russia gains Crimea virtually without bloodshed, what is to discourage China from asserting its claims in a similarly aggressive manner?

The Russian stock market fell sharply in immediate reaction to the crisis. If investors continue to flee, that may be the strongest incentive for Russia to moderate its position.

Impact on stocks, bonds and savings accounts

The U.S. stock market's reaction to all this was wildly negative one day, than bizarrely euphoric the next. The first reaction may have been more on the money.

Unless Putin pulls all the way back from the brink -- that is, not only withdraws Russian troops but also stops supporting separatists in Crimea -- this situation is going to have consequences. Sanctions will be exchanged, and the world will anxiously await the next land grab, whether by Russia or some other nation.

As noted above, the economic consequences are likely to be slower growth and higher inflation. That is a bad recipe for stocks, bonds and savings accounts:

  1. For stocks, slower growth will keep a lid on earnings. Meanwhile, a rise of inflation will hurt stock valuations by pushing up interest rates.
  2. For bonds, rising inflation would mean rising yields. Bond yields only rise one way: by having prices fall.
  3. Savings accounts have not even been able to keep up with a low rate of inflation. The situation in the Ukraine could accelerate inflation, while slower growth would continue to hold bank rates back.

Ever since the financial crisis and the Great Recession, the global economy has been in a fairly fragile state. To twist an old simile, Putin's adventures in the Ukraine may prove to be like letting an angry Russian bear into a china shop.

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Stock market rises despite tanking dollar

February 21, 2014

| Senior Financial Analyst, CFA

So far, the month of February has seen the stock market rally impressively, while the value of the U.S. dollar has slipped. Are currency traders and stock market investors reading different newspapers?

As inconsistent as the actions of U.S. stocks and the dollar might seem, they have a root cause in common: weakness in the U.S. economy.

A currency trader's perspective

Some speculate that the accumulating evidence of weakness in the U.S. economy will force the Federal Reserve to prolong its easy monetary policies. From a currency trader's perspective, aggressive monetary stimulus does two things: It lowers interest rates, and it erodes the creditworthiness of the government. Both of these reduce the attractiveness of the dollar.

The dollar's slide might be more pronounced, except that other economies are so dependent on the U.S. as a trading partner that what is bad for the U.S. generally touches other nations as well.

The stock market's perspective

While the dollar has stumbled, the U.S. stock market has regained just about all the ground it lost in January. Why is Wall Street so happy? Because those same low interest rates that undermine the dollar help to boost the relative attractiveness of stocks. In fact, in many cases the weak dollar is a bonus to U.S. companies, because it improves their pricing position relative to foreign competitors.

Perhaps the biggest short-term win for the stock market may come with the Federal Open Market Committee's next meeting in mid-March. That's when the Fed will announce whether it will continue to taper back its quantitative easing program. If the weakening economy forces the Fed to slow down the tapering schedule, it will signal that low interest rates are here for a while longer.

Ultimately though, stock investors may regret getting too exuberant over low interest rates that are a result of a weak economy. Low interest rates may improve the relative value of company earnings, but ultimately those earnings have to grow for a stock to make sustainable progress. In a weak economy, earnings growth will be hard to come by.

It's unanimous: Savings accounts lose

While the dollar is going down and the stock market is going up, both reflect the same thing -- more downward pressure on interest rates.

This means that savings accounts join the U.S. dollar among the losers in this situation. Not that interest rates on savings accounts are likely to drop -- they are already so close to zero that is hardly possible. However, any hope of them finally rising in the first half of this year is quickly vanishing.

Of course, home buyers and home owners may benefit from lower mortgage and refinance rates. However, the boost from lower rates may be negated if the deteriorating economy makes loans harder to come by. Mortgage shoppers and stock market investors may find that a weakening economy is not good news for anybody in the long run.

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