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The winds of change may be making their way into deposit yields.
The yields on long-term certificates of deposit -- anything longer than one year -- have bounced off the record-low levels and are now at the highest point in the past month. In the past two weeks, more institutions have actually been boosting yields on long-term maturities than cutting yields on short-term maturities.
With the expected Federal Reserve interest rate cut on Dec. 11, this short-lived streak may come to an end as yields on liquid and short-term deposit products continue to fall. However, the trend of increasing long-term yields may quickly resume, especially if the Fed hints at a turn for the better in the economy's fortunes.
Why the divergence between rising and falling yields on different maturities?
The short-term interest rate environment still contains some evidence of economic weakness, the expected rate cut Dec. 11 and the possibility of another in January.
Longer-term prospects, on the other hand, are looking up. There is optimism that the economy may be bottoming, and that the significant stimulus of the cumulative interest rate cuts and additional government spending bode well for some measure of economic rebound in 2002.
This hoped-for rebound and all it carries with it -- improved performance in other risky assets such as stocks and potential for higher inflation in the future as the economy picks up speed -- mean investors now command a higher return when investing for longer periods.
How should investors react? This is not the green light to jump headlong into longer-term maturities. Certificate of deposit yields are still near record low levels, and this is not the return investors want to be locking-in for the long haul. As the economic rebound materializes, look for further improvement in yields during the coming year.
Optimum CD returns can be earned by staying short-term for now, six months at most, and looking to lock into longer maturities next year after yields have rebounded. This strategy works for those investors using cash investments to diversify their overall portfolio or those just initiating a laddered structure, one where funds are invested to mature at regular intervals. Establish the furthest rungs of the ladder next year when higher returns prevail.
For example, instead of investing in a three-year CD today, the investor can remain in short-term instruments and invest in a two-and-a half-year CD in six months, or a two-year CD one year from now.
The exception is an investor who currently has a laddered portfolio. They are currently reaping the rewards of having diversified the portfolio over a range of maturity dates. As a result, their exposure to reinvesting at this low point is largely reduced relative to someone looking to reinvest the whole enchilada.
There is no need for these investors to upset the laddered structure -- specifically the space between the rungs. Disrupting the regular space between the rungs on a ladder could leave the investor short of funds at a critical time in the future -- and cause a nasty fall.
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