Will deposit yields keep rising?

The beneficiaries of the nine interest rate hikes by the Federal Reserve have undoubtedly been savers and investors with certificates of deposit and money market investments. Yields have improved from historic lows throughout the past year, with the average yield on a six-month CD rebounding from 1.08 percent in June 2004, when the Fed first boosted rates, to 2.4 percent now.

Yields on CDs closely track the movement in Treasury yields. This has meant solid improvement in yields on shorter-term instruments that are more influenced by Fed interest-rate moves, but lackluster improvement on longer maturities such as the five-year CD, which is not tied to the Fed.

But with continued interest-rate increases expected by the Fed, the outlook should be bright for savers, right? Not quite; the fact that longer-term interest rates have not climbed -- or have fallen -- could keep a lid on deposit yields of all maturities, even if the Fed continues raising short-term interest rates.

The dilemma of rising short-term interest rates and falling long-term interest rates is referred to as a "flattening yield curve." The yield curve is the plot of Treasury yields from short maturities through long, and it typically takes an upward slope as investors command higher returns for investing over a longer period of time. A flattening of this curve results when the difference between short- and long-term yields narrows, as it has considerably in the past year.

The connection between the flattening yield curve and the lack of improvement in five-year CD yields seems fairly straightforward. But what does this have to do with what banks are paying on short-term CDs or money-market deposit accounts? For that, let's take a closer look at how banks make money.

Banks, especially big banks, make money in three primary ways: lending, securities gains and fee income. Lending is dependent upon the net interest margin, the difference between the rate at which the bank borrows, and the rate at which the money is lent.

Consider the following passages from the FDIC's Quarterly Banking Profile for the first quarter of 2005.

"In an environment of rising interest rates, funding costs rose more rapidly than asset yields during the quarter, causing net interest margins to decline.

"The industry's net interest margin in the first quarter was the lowest registered in almost 15 years."

Funding costs refer to the yields that banks pay on deposits, as this is the money that is ultimately lent out at higher rates. When the cost of raising those deposits increases, without a commensurate increase in lending rates, the net interest margin declines. Clearly, this is not a condition that can persist indefinitely.

Much of the gains that banks have enjoyed from the sale of securities have come from what is known as the "carry trade." The carry trade is where banks profit from the difference in yield on short- and long-term instruments, borrowing from depositors at low rates and investing in long-term bonds that carry higher yields. The larger the difference between short- and long-term interest rates, the more money that can be earned via the carry trade. But with the yield curve flattening, this gravy train is coming to a halt.

As profit margins wane in these two key areas, so too does the need for banks to raise additional money through deposits. And, consequently, the ability and willingness to pay steadily higher yields on short-term deposits even as interest rates continue to climb is constrained.

This is not to paint a dark picture for the future of banks by any means. After all, there is a third and very significant component to bank profitability that is not dependent on interest rates -- fee income. As demonstrated by the increases in ATM fees and bounced-check charges found in the latest Bankrate.com Checking Study, fee income remains very important to bank profitability, and consumers need to remain alert to dodge fees.

In the past year, CD yields have kept pace with the increases in Treasury yields, but this trend seems endangered by the flattening yield curve and its effect on banks' demand for deposits. While the importance of fee income is unlikely to diminish, continued improvement in CD yields is dependent upon a normal relationship between short- and long-term interest rates.