yield curve

Case Study Short-term interest rates tend to be much more volatile than long-term interest rates. Thus, the yield curve is somewhat like a rope, with rapid up-and-down movements on the left end, which displays short-term rates, and gradual changes on the right end, which depicts long-term rates. Somewhat surprisingly, the two ends of the yield curve don't always move in the same direction. The Federal Reserve attempts to work its economic magic by influencing short-term rates. In particular, the Fed sets the discount rate (the rate at which banks can borrow from the Fed) and establishes a target for the federal funds rate (the rate at which banks borrow reserves from one another). A Federal Reserve decision to reduce short-term rates in an attempt to stimulate the economy can cause long-term rates to increase if lenders and investors are concerned a stronger economy will be accompanied by higher inflation. Inflationary expectations have a direct effect on long-term interest rates. On September 18, 2007, the Federal Reserve announced it was reducing the target rate for federal funds from 5.25% to 4.75%. This half-point decline was larger than anticipated and was accompanied by an increase in stock prices and declines in other short-term rates, including CD rates, Treasury bill rates, and the prime rate (the rate offered by banks to high-quality borrowers). On the same day that short-term rates declined, the rate on 10-year U.S. Treasuries experienced a slight increase. One month later, the rate on 10-year Treasury bonds was even higher.

I have noticed that short-term CDs are currently yielding more than CDs with longer maturities. Should I take advantage of the higher short-term rates even though I don't expect to need the funds for many years?

It depends. You must consider the reinvestment risk. That is, what will your reinvestment rate be when the short-term CD matures? If the yield curve falls and both long- and short-term rates are lower, you may lose money. You may be better off taking a long-run view of your investment strategy. On the other hand, if you stand to make a substantial return on your short-term CD investment, the potential return may well offset the reinvestment risk. Yield curves are normally upward sloping, so there may be a good chance you can reinvest at a higher rate when the short-term CDs mature.

Michael W. Butler, PhD, Professor of Economics, Angelo State University, San Angelo, Texas