bank rates

CD Rates Responded Quickly The Last Time The Fed Pushed Interest Rates Higher

For savers investing in certificates of deposit, the question of when the Federal Reserve will finally start raising rates is fueled by more than a simple desire for higher returns to arrive.

It’s also about multiyear planning and how to make smart CD choices in a period of rising yields.

To help you make return-maximizing decisions, let’s take a look at what’s expected from the Fed over the next few years, what that might mean for CD rates during that period and what you can do to Fed-proof your CD portfolio.

The last time the Fed governors responsible for managing the nation’s money supply pushed interest rates as high as they’re planning to do now, which was back in 2004 and 2005, commercial banks responded with significantly higher interest rates on bank deposits.

The average return for 1-year CDs rose to nearly 3%.

The average 5-year yield reached nearly 4%.

That’s far more than even the best CDs pay today.

If our banks just follow the Fed’s lead in a similar way over the next several years, savers will finally enjoy a good run of reasonable returns.

Expectations from the Fed

For almost seven years now, the Federal Reserve has kept interest rates anchored at historic lows as a stimulus to lift the economy out of the Great Recession.

It did this by reducing the federal funds rate – the interest that banks pay to borrow money through the Fed – all the way down to essentially zero in December 2008 and keeping it tethered there ever since.

That’s allowed banks to get almost all of the money they need for loans free through the Fed and in turn slash what they’re willing to pay savers for deposits.

With the economy now significantly stronger, the Fed’s rate-setting committee is on the precipice of launching a series of rate hikes aimed at returning the federal funds rate to a more normal level.

This will be welcome news for savers because, when banks need our money again, they’ll need to offer more competitive yields to attract our deposits.

Like savers everywhere, we were disappointed last month when the Fed once again refrained from raising rates, deferring the first increase until at least the end of this month, but more likely to December.

Whenever the Fed governors eventually kick off the hikes, official surveys and statements indicate they’ll push rates higher very gradually over the next several years.

Whereas past periods in Fed history have seen quarter-point increases made at each of the rate-setting committee’s eight meetings a year, it’s anticipated that in this new era, quarter-point increases may only be made every other meeting.

That would result in total increases of about 1 percent per year over the next three years until the fed funds rate reaches the ultimate goal of 3.50%.

However, there are absolutely no guarantees on whether the Fed will act as the market expects, or even as they themselves predict right now, since their heavily data-dependent decisions are made at each meeting in light of economic indicators available at that time.

The Fed’s Impact on CD Rates

An extended period of near-zero rates is unprecedented in modern Fed history.

In the 25 years leading up to the 2008 financial crisis, the federal funds rate was never set lower than 1.00%, which occurred for about 12 months from mid-2003 to mid-2004.

In contrast, its lowest target rate throughout all of the 1990s was 3.00%, and in the 1980s, it was never lower than 5.875%.

You can see how different this makes today’s scenario – where the rate has sat at about zero for almost seven full years – and why it’s difficult to predict where rates will go from here and over what time period.

Still, we can’t help but wonder what kinds of CD returns would be reasonable to expect if annual 1 percent Fed increases come to fruition.

To find out, I dug through the fed funds rate history as well as the national bank averages for 1- and 5-year CDs starting with the 2003-2004 period when the Fed held rates to 1.00% for about a year.

The period that came afterward is the closest chance we have for predicting what will happen over the coming three years, because in June 2004 the Fed began steady increases for more than two years, raising the rate a quarter point every meeting for a total of 2 percentage points per year.

It’s twice the pace that’s being predicted now, but can still perhaps give us some insights into what might be expected from banks when the fed funds rate is 1.00%, 2.00% or 3.00%.

How A Rising Federal Funds Rate Influenced CD Rates 2003-2005

Target Federal Funds Rate Average 1-Year CD APY Average 5-Year CD APY
0.00% today 0.28% 0.86%
1.00% in 2003-2004 1.26% 3.02%
2.00% in 2004 1.87% 3.50%
3.00% in 2005 2.71% 3.76%
3.50% in 2005 2.95% 3.80%

As you can see, the growth in rates could be dramatic over the next three years, especially when you remember that these are national averages among all banks and thrifts, in stark contrast to the leading national rates we feature on our CD Rates Leaderboard.

Again, however, it cannot be overemphasized that we are entering completely uncharted territory – not only for savers but for the Fed governors and banks as well. On top of not knowing whether steady 1 percent increases will actually come to pass over the next three years, we also don’t know if banks’ deposit rates will follow a similar correlation to the fed funds rate.

Smart Moves to Fed-Proof Your CD Portfolio

So what’s a savvy CD investor to do?

We have half a dozen tips to help you protect against lost opportunities and maximize your overall return as we enter this brave new world of increasing rates.

First, focus on short- and mid-term certificates. Given the expectation of steadily increasing rates over the next three years, 1-3 year CDs are smart bets as they’ll allow you to reinvest your matured CDs at higher rates (perhaps after fed funds rate peaks). In addition, shorter CDs won’t unduly lock you into a long-term yield that’s below what you’ll be able to secure in the coming years.

Second, if you must buy long-term certificates, be careful to choose CDs from leading banks that impose only reasonable early-withdrawal penalties. National CD leaders like Ally, Barclays, Capital One 360 and Synchrony offer high rates alongside some of the lowest penalties, making them acceptable options for breaking after two or three years in order to capitalize on a new, higher rate.

Third, just as with all investments, diversify. Putting all of your CD funds into a single certificate, single term or single rate leaves you without any leverage to take advantage of increased yields when they begin arriving.

This is a perfect time for CD laddering, a strategy in which you buy an array of certificates in increasing terms. Ladders are touted for providing you with periodic access to a portion of your funds. But in an environment of rising rates, ladders have the added advantage of making it possible to continuously reinvest in better-paying CDs as they come along.

Although a traditional CD ladder includes terms of one through five years, consider a 3-year CD ladder for the next few years until locking in a long-term rate makes more sense.

Fourth, shop around for your CDs among both the national banks on our Leaderboard and the local deals in our constantly updated roundup of the best credit union and community bank CDs. There’s no place in a smart CD portfolio for national average yields when you can earn three, four or even five times more by securing a chart-topping rate.

Fifth, keep your eye on the top-paying savings and money market accounts. If a CD you’re considering pays less than the rates on our Savings Account & MMA Leaderboard (as most 3- and 6-month CDs do), stash that cash in a liquid account for now, perhaps later moving it to a longer-term CD when rates have improved.

Lastly, follow any news and developments from the Federal Reserve, including noting the rate-setting committee’s calendar of eight meetings per year. This will help you avoid locking in a CD right before a rate hike potentially takes place.

Despite the various uncertainties, one thing you can count on is that the coming months and years will be interesting ones in banking history. And we’re as anxious as anyone for that train to finally leave the station.

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