An article in CNN Money piqued my interest. It states that many banks are worried about a future of rising rates on deposits. As the article states:

"Lenders have benefited handsomely as a result, borrowing money cheaply and making long-term loans with healthy profit margins. But expectations are growing that the nation's central bank will soon reverse its loose monetary policy stance in an effort to tamp down the threat of inflation."

Regulators are worried that when this dynamic reverses itself, many banks will face financial problems and some could fail. In its quarterly conference call last week, Wells Fargo said it expects a rapid increase in rates sometime in the future. This would be troublesome to smaller banks that don't have the interest rate hedging tools employed by their more sophisticated, larger counterparts.

The best way to counter this interest rate risk is to lock as much of their deposit portofolio into longer term CDs. As a result, I expect we'll see many banks promoting 3-5 year cds and loosening early withdrawal penalties. Banks know that once a consumer opens a CD, inertia often keeps them in it regardless of the relative rate. Ally Bank recently lowered their early withdrawal penalties.

Some of the bigger banks may even benefit from rising rates. Wells Fargo stated that they are not deploying their cash not, but are keeping their powder dry in anticipation of higher future loan rates. Why lock money up in a 30 year mortgage paying 5% when they might be able to get 6.5% or even 7% in a year or two?

Savings and CD rates continue to hover at pitiful rates. Average savings rates reached a new record low of 1.51% APY last week, down 3 basis point from 1.54% APY the previous week. Average one-year cd rates actually rose 3 basis points 1.95% APY. Average three-year and five-year CD rates remained steady at 2.67% APY and 3.18% APY respectively.

Last week was nother relatively quiet week in the markets. News was dominated by the devestating earthquake in Haiti as well as the battle over healthcare and the election in Massachusetts. I live in Massachusetts and never in my life have I seen so much campaigning. Usually Massachusetts receives little to no attention in national elections since the race is usually a foregone conclusion. Now, every twenty mintes the phone is ringing with an ad for one candidate or the other and almost every commercial is an election ad.

The stakes are large no matter who wins. Health care eats up 16% of the Federal budget and that number is expected to rise as the cost of healthcare continues to grow at 7-10x the rate of inflation. A friend of mine works in the benefits department of a major corporation and he told me that no matter what happens, the quality of healthcare is going down, or the price is going up. Companies can no longer afford to subsidize as much of the cost. Many of you have already seen it in high-deductible plans or plans with very expensive premiums. Expect this trend to continue.

Now, onto the rates.

CD and Savings Rates

Savings and CD rates continue to hover at pitiful rates. Average savings rates reached a new record low of 1.51% APY last week, down 3 basis point from 1.54% APY the previous week. Average one-year cd rates actually rose 3 basis points 1.95% APY. Average three-year and five-year CD rates remained steady at 2.67% APY and 3.18% APY respectively.

Like the Treasury yield, BestCashCow has developed its own yield ratio for deposit accounts - the spread between savings rates and 36-month CDs. In some ways, this ratio is purer because it cannot be influenced by government debt, Fed Treasury purchase programs, and other attempts to manipulate rates. As you can see below, the ratio between savings accounts (a short duration deposit account) and 3-year CDs is 1.15%. Savings and money market rates have dropped while 3 year cds have essentially stayed flat. The ration remains very elevated, mimicking the Treasury curve. We'll be watching how the ratio develops over the next month to see if it provides any additional clues to the state of the market in 2010.

At this point it's still hard to recommend putting money into anything longer-term than a 12-month CD, especially with rising equity markets and signs that the economy may be coming back to life. Many depositors may be willing to lock money away for 5-years at close to 3%. To me that's just not enough of a return for that period of time. For those worried about interest rate risk, cd laddering may be a good way to smooth out the return you receive from your CD portfolio.