MoneyRates Blog

The mix of factors now prevailing in the financial markets is almost the perfect recipe to challenge anyone depending on CD rates, savings account rates, or money market rates. In other words, it may be the perfect poison for bank rates. Fortunately, markets eventually tend to find antidotes to their own ills.

First the poison, then the antidote.

The poison consists of three ingredients:

• A U.S. dollar which has been steadily sinking. The weakness of the dollar can be seen immediately in the rising price of oil, but eventually it will show up in the prices of all imports, creating inflation pressure here in the U.S. Bank rates are really only as good as the premium they offer over inflation. When rising inflation squeezes that premium, depositors suffer.
• Signs of life in the U.S. economy. At least, the stock market seems to think the economy is on the right track. If the rising stock market is right, a strengthening economy would spell the end of the deflationary period, and another reason for the return of inflation.
• Government policies committed to keeping interest rates low. The government (like many experts) views the recovery as fragile, so they are going to do everything they can to keep interest rates at low, stimulative levels for as long as they can.

So much for the poison. The antidote? That also comes in three parts:

• A strengthening economy would increase demand for capital, which would make banks offer higher rates to attract depositors.
• Rising inflation would force the Federal Reserve to raise rates before inflation gets out of hand.
• Without waiting for those market forces to come around, you can mitigate the effects of the poison by shopping actively for the best bank rates. The spread between the best and average bank rates is huge.

The fact that home sales rose in 45 out of 50 states in the third quarter may, eventually, mean that interest rates on CDs, savings accounts, and money market accounts are headed higher.

The connection between higher home sales and higher deposit rates is far from a taut equation, but think about it for a second:

Who–and, perhaps more importantly, how are a large percentage of new home sales being funded right now?

The answer as to how can be seen as two-fold:

1. In the first case, investors, many of them foreign residents, are buying “distress sale” properties at deep discounts.

2. In the other case, first time homebuyers are snapping up reasonably priced homes and taking advantage of low downpayment FHA loans or help with a downpayment from parents or relatives.

These two demographics, just like the young spender and the more mature saver, are connected. Often, the investors purchase the home, fix it up, and attempt to sell it to first time homebuyers.

Just as often if not more often, though, both groups are seeking to retain ownership of the property they buy.

The point of all this, if you’re looking to see CD rates go higher, is that the current dynamic entails more dollars going out of deposit accounts and into hard assets, including good old land in the U.S.A.

Over time, one would think that less deposits available would make deposits more valuable to banks, driving up CD rates.

As the economic recovery gets haltingly underway, one of the things depositors should keep an eager eye on is lending volume. It’s not that those depositors are necessarily looking to borrow money themselves, but a pick-up in the lending business may be a key in pushing bank rates higher.

You name it — CD rates, savings account interest rates, and money market rates have all been unusually low this year. There are many factors contributing to low bank rates, but one of them has to do with a dilemma banks have faced in the wake of the financial crisis.

In an effort to stabilize their businesses, bankers have sought to lower their loan-to-deposit ratios. Basically, loans represent a source of risk to banks, and deposits represent the liquidity that helps mitigate that risk. The problem is, as banks take on deposits while writing fewer loans, it becomes more difficult for banks to turn a profit on those deposits.

When the loan business is profitable, it means banks are earning more by lending out the capital they receive in the form of deposits. This makes those deposits more valuable to the banks — which means banks are willing and able to pay more in the form of interests on those deposits.

When the lending business stagnates, bank rates suffer because deposits can’t be put to profitable use. Bank rates would get a boost if lending business picks up, assuming that lending business is healthy (i.e., if default rates are low). So, depositors need to root for a pick-up in the loan business — even if they have no need of a loan themselves.

In one of the more interesting bank stories of the new century, investment bank Goldman Sachs and renowned investor Warren Buffett want to buy $3 billion worth of federal tax credits from Fannie Mae, the government-owned mortgage finance company.

Government regulators are unsure of the fairness of such a deal because the tax credits would reduce the federal income taxes owed by Goldman Sachs and Warren Buffett.

Fannie Mae, however, could use the $3 billion. It is estimated that the government has put more than $100 billion into Fannie Mae with no end in sight as to a return to profitability.

What’s more, Fannie Mae cannot use the tax credits because the company already has so many losses that it owes no federal income tax this year, and will likely not owe any federal income tax for many years to come.

Fannie Mae’s continuing and widescale purchasing of mortgages from banks has helped to keep mortgage interest rates low, so it is difficult for even the most hardcore libertarian to long for the company’s total demise.

The tax credits in questions were originally put into law under President Ronald Reagan, in 1986, as part of an affordable housing program.

It’s not surprising that former Fed Chairman Paul Volcker has voiced the opinion that banking reform must include the break-up of large institutions, including the separation of commercial and investment banking operations. However, having John S. Reed’s voice join the same chorus is really reason for pause.

Paul Volcker’s regime as Fed Chairman was strikingly different from that of his successor, Alan Greenspan. Volcker did not consider himself the cheerleader-in-chief for the growth economy, and his greatest achievement was in helping to finally choke off the inflation trend which had snowballed in the 1960s and 1970s. Volcker was willing to fight inflation even at the expense of some short-term economic growth, and it paid off in the long run. Given this conservative approach, his view in favor of unhooking conservative and risky lines of bank business is perfectly in character.

Reed, on the other hand, is one of the founding fathers of the modern mega-bank, having merged his Citicorp with Travelers to form Citigroup. Now, however, Reed has stated that some separation between commercial and investment banking activities would make sense.

Will reform get there, or will it continue to nibble around the edges? Ultimately, what legislators don’t accomplish with reform, bank customers can achieve by voting with their feet.

Customers will continue to shop for the best bank rates on CDs, savings, and money market accounts. They will also take reputation into consideration when choosing a bank, and right now, that favors smaller, less-complex institutions. A MoneyRates.com poll a few  months back showed that bank customers preferred local community banks and credit unions by an overwhelming 4-to-1 margin over large national and international banks. If the business of banking customers follows this preference, it may largely achieve the separation of business that reformers want.