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As short-term CDs ascend, long-term rates stay low
Your Money Outlook by Greg McBride, CFA

Greg McBrideIn stark contrast to the record-low returns of the past several years, certificate of deposit yields are on the rise and savers are rejoicing. Over much of the past year, week in and week out, CD yields have been on an upward track. Thanks to Alan Greenspan and the Federal Open Market Committee's intention of raising interest rates further, there promise to be many more such weeks to come.

The improvement in CD yields has been slow, but it has been consistent. Over time, this has produced some nice effects for CD investors as yields on CDs with maturities of one year and less have more than doubled since March 2004. The average one-year CD yield that was 1.1 percent last March is now 2.39 percent. The same is true of the six-month CD, which stood at 0.93 percent last March and now stands at 2.0 percent. Investors can tack an additional percentage point of yield onto their returns, while maintaining FDIC insurance protection, by investing in the highest-yielding CDs available nationwide.

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Sparking the improvement in CD yields are the six interest rate hikes enacted by the Federal Reserve since June 2004, just as the 13 rate cuts between 2001-2003 pushed yields into the cellar. And the good news is expected to continue as more Fed rate hikes are expected as 2005 unfolds.

However, the improvement has not been so evident on longer-maturity CDs. Yields on intermediate and long-term Treasury securities, those with maturities of three years and longer, have not behaved in the same way as yields on short-term instruments that are strongly influenced by Fed action. The same phenomenon that recently brought mortgage rates down to 11-month lows has produced lackluster improvement in the longest maturity CDs.

Look at the average five-year CD yield as an example. On June 30, 2004, the average yield was 3.6 percent, having climbed from 2.89 percent in March. But the average yield is just 3.62 percent now, with improvement having ground to a halt even as the Fed has continually raised interest rates. Why? The five-year Treasury yield that was 3.81 percent on June 30 when the Fed raised interest rates for the first time fell to 3.71 percent by mid-February.

The two-year and three-year CD yields have fared slightly better. The average two-year CD yield increased from 1.62 percent in March 2004 to 2.3 percent by the first rate hike on June 30, continuing to climb to 2.83 percent now. The average three-year CD yield also increased sharply between March and June 2004, from 2.12 percent to 2.82 percent. But from June until November, the average yield was essentially flat, inching to 2.84 percent on Nov. 3. In the three months since, yields have increased to 3.13 percent, spurred by yields on three-year Treasuries that increased from 2.85 percent to 3.76 percent in the same time frame.

A complete rebound in long-term CD yields is dependent upon intermediate and long-term Treasury yields rising from what appear to be unreasonably low levels. During Alan Greenspan's Senate testimony Feb. 16, he referred to this as a "conundrum," implying that even the Fed Chairman is mystified as to why. The rate of economic expansion and repeated Fed rate hikes that are expected to continue through much of 2005 point to higher rates across the entire spectrum -- not just on the shortest maturities.

-- Updated: March 8, 2005

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