Strategy Is Key as Rates Rise

Buyer’s remorse has been a staple emotion for many investors who’ve locked in yields on short-term savings instruments over the last year.

For most of that period, interest rates on bank certificates of deposit and Treasury bills have been rising steadily, as Federal Reserve policymakers have boosted their benchmark short-term rate at every meeting. Which means no sooner did you buy that six-month T-bill, say, then yields on new ones were higher than what you got.

When the Fed meets Tuesday, its key rate is virtually certain to rise another quarter-point, to 3.50% from 3.25%. And once again, the central bank is unlikely to provide the one bit of information that every investor would really like to know: When will they be finished lifting rates?

To be fair, they can’t tell us because they themselves probably don’t know how much more credit tightening the economy needs, or can stand.

All of this means that people who are trying to manage their cash for the best returns may need to think more about strategy than they would normally care to do. No single action plan is right for everyone, of course, but there are some general guidelines that may be helpful to most savers and investors:

* Don’t be in a hurry to lock in shorter-term yields, meaning those on instruments maturing in one year or less.

True, nobody knows when the Fed might call it quits. But given the economy’s apparent strength this summer, among other considerations, most analysts doubt the central bank will be finished with Tuesday’s rate hike. That was reinforced by the government’s report Friday on July employment trends, which showed a bigger-than-expected increase in net new jobs.

Some analysts think the Fed will want to get to the 4% level with its benchmark rate. That would mean three more quarter-point increases, including this week’s. Others see the rate going to 4.5%, or higher, sometime in 2006.

The upshot is that rates on bank CDs and Treasury securities of one year or less in term are likely to keep rising for the next few months, at least. Yields on savings instruments in that maturity range typically follow expectations for the Fed’s key rate.

In May 2000, when the Fed’s benchmark reached its zenith of 6.5% in that tightening cycle, the six-month T-bill yield also peaked at 6.5%. The T-bill now is at 3.74%. If the Fed raises its rate a quarter point at every meeting between now and year’s end, that benchmark will be 4.25% by Dec. 13. If history is a guide, the six-month T-bill could be at that level by or before December.

* Two-year T-notes also may be a bad bet, for now.

As with shorter-term rates, yields on these popular securities tend to follow expectations for the Fed’s rate. The two-year T-note was yielding about 4.11% as of Friday.

“Rates are going higher. The two-year note doesn’t hold any allure for us” at current levels, said David MacEwen, chief investment officer for fixed income at American Century Investments in Mountain View, Calif.

Talk about buyer’s remorse: Some investors locked in two-year T-notes at yields of 2.4% a year ago, when there was talk that the Fed might only boost its rate to 2% or so, then stop. (The Fed’s rate was just 1% when it began tightening in June 2004.)

It can’t feel good to be stuck with a yield of 2.4% for another full year, when even three-month T-bills now are paying 3.5%. Patience was a good strategy in cash management last year, and it still is, many experts say.

* Shorter-term market rates probably will begin to ease before the Fed stops -- but they may not plummet.

The Fed kept short-term rates at generational lows from mid-2002 to mid-2004 because it believed the economy was in dire straits. Hopefully, those days are gone for good.

If the economy is growing moderately in 2006, the Fed might just hold its key rate steady at, say 4% or 4.5%. In other words, it might stop raising rates, but it might not seek to cut them, or cut them much. If that’s the case, Fed policy would effectively put a floor under savings rates.

That’s what happened a decade ago, when the Fed tightened credit through 1994 and into the first quarter of 1995, lifting its rate to 6%. Then it stopped, and held steady until July 1995, when it made a quarter-point cut.

The six-month T-bill yield peaked at 6.7% at the end of 1994, then drifted down in the first half of 1995, as investors waited to see what the Fed would do. By July, just before the Fed cut, investors could still pick up a yield of 5.5% on six-month T-bills.

* The compensation for being patient is rising, if you’re using money market mutual funds.

The funds buy short-term corporate and government IOUs, so as those rates rise with Fed rate hikes, so does your yield. The average money market fund yield now is an annualized 2.73%, according to fund tracker ImoneyNet.com in Westborough, Mass. That’s up from 2.3% at the beginning of May and 1.6% at the start of the year.

* If you routinely roll your cash over in bank CDs, you may need to become more vigilant about yields.

Banks have been raising rates over the last year as the Fed has tightened. The average six-month CD yield has risen from 1.25% a year ago to more than 2.4% as of last week, according to Informa Research Services of Calabasas.

But banks aren’t obligated to pay you a market rate. And because their earnings are being squeezed by higher deposit costs, some banks may begin to slow their deposit-rate increases, warned Greg McBride, analyst at Bankrate Inc. in North Palm Beach, Fla.

“Even if the Fed continues to raise rates, that doesn’t guarantee a similar increase in CD yields,” he said. That means savers will have to watch more closely as their CDs come up for renewal, and be willing to compare what their bank is offering versus yields at other institutions.

“Laddering” CDs -- dividing your savings among, say, three-, six-, nine- and 12-month CDs -- is a good strategy as rates are rising. But shopping around on websites like bankrate.com could net you a much higher return on your savings dollars than laddering within a single bank. And because federal deposit insurance offers the same coverage at every insured bank, there’s no good reason not to seek out the highest CD yields.

Or consider Treasury bills in place of bank CDs. You can buy them direct from the Treasury, without paying commissions, for a minimum of $1,000 at www.publicdebt.treas.gov. And one key advantage of T-bills over CDs: The interest T-bills pay is exempt from state income tax.

* If you’re hoping to lock in longer-term interest rates at whatever their peak may be, the Fed is only one consideration.

The Fed controls short-term rates, but it doesn’t control long-term rates; those are set in the market place, as has become very clear in the last year. The 10-year Treasury note yield was at 4.39% on Friday. It was 4.2% a year ago. So even as the Fed has raised short-term rates two percentage points, the 10-year T-note has risen only a bit.

Why such relative stability? A major reason must be that investors believe inflation won’t surge, because inflation eats away at fixed returns.

Beyond that, it may be, as some experts have proposed, that the world is simply awash in cash looking for decent returns. Investors aren’t being paid much more in a 10-year T-note than in a two-year T-note. That suggests that many people believe rates in general are getting closer to a peak -- because, at that point, a yield locked in at 4.39% for 10 years could be far more appealing than a yield of 4.11% locked in for just two years.

If you figure the economy will slow by year’s end or early in 2006, the time may come in the next few months to lock in longer-term yields. “If growth slows, the 10-year T-note could be at 4% again” as investors rush in, said Tom Higgins, chief economist at investment firm Payden & Rygel in Los Angeles.

But to accept that low a return, you also would have to believe that neither the Fed nor inflation poses a greater threat to long-term rates over the next few years. That could be asking a lot.

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Tom Petruno can be reached at tom.petruno@latimes.com.