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Flight to safety: Should you invest in long-term CDs?

August 08, 2011

| MoneyRates.com Senior Financial Analyst, CFA

With the stock market taking a nosedive on the U.S. credit rating downgrade and continued fiscal troubles in Europe, you might be looking for a place to move your money and wait out the volatility. Should you move your money into long-term CDs?

One of the strange things--and there are many--about the recent economic environment is that while it has been a tumultuous year for global financial developments, interest rates on CDs have been extraordinarily calm. In the financial world, calm can be good, but CD rates are cruising at very low altitude, indicating economic pessimism that may be settling in for the long term.

Long-term CD rates offer less compensation

Let's start by considering the shortest end end of the CD range. One-month CD rates are reflective of current economic and banking environments. Historically, 1-month CD rates have averaged 6.07 percent. As recently as December 2007, the 1-month CD rates were above 5 percent. But by the end of 2008 they slid to 1.04 percent, and by the end of 2009 they were down to a measly 0.18 percent. They've shown little life since and currently sit at 0.12 percent.

Five-year CD rates should generally offer more yield than 1-month CD rates, but this advantage is dissipating. At the end of 2009, 5-year CD rates were 1.88 percentage points higher than 1-month CD rates. Since then, though, while 1-month rates have fallen another 13 basis points (0.13 percentage points), 5-year CD rates have fallen by 58 basis points (0.58 percentage points). This has narrowed the gap: 5-year CD rates now are only 1.43 percentage points higher than 1-month CD rates.

There is not a very long series of historical data available from the Federal Deposit Insurance Corporation (FDIC) for 5-year CDs, but we can observe a little more about the relationship between short and longer-term CDs by looking at the spread between 1-month CDs and 6-month CDs. This history goes back to the end of 1965. Just since the end of 2008, the spread between 1-month and 6-month CDs has fallen from 1.14 percent to 0.16 percent. The latter is below the historical average spread of 0.24 percent.

The picture this paints is that short-term CD rates were the first to react to weaker economic indicators and news, but now longer-term CD rates are catching up with the pessimistic view. As the premium for investing in longer-term CDs shrinks, there is less incentive to put money into laddered longer-term CDs.

Of course, if you don't have the iron stomach for keeping your money in the stock market right now, both short-term and long-term CDs could be the right place to park your money. After all, even though the advantage of longer-term CDs has eroded, CDs are still FDIC-insured deposits that will protect your principal.

Interest rates on CDs and pessimism

CD rates are not purely a function of optimism or pessimism. Inflation affects CD rates, and over the course of history the prevailing interest rate environment has reflected different norms as to what was considered a "high" or "low" CD rate. In the 1980s, for example, a 6 percent CD rate would have been considered very low. Now, it seems astronomical.

Still, in the current environment, CD rates do largely come down to optimism or pessimism about the economy. Until banks regain confidence in their ability to lend money profitably, they will have little need for taking in money via deposits. The general course of CD rates over the past few years shows increasing pessimism--but now, with the way longer-term CD rates are following short-term CD rates down, it appears that we're settling into pessimism for the long run.

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