Oil, Economics and Bank Growth will lift CD Rates in 2011

Did you know there is an interest rate war going on? It’s true. In one corner you have Wall Street, Ben Bernanke and all the consumers still burdened with mortgage and credit card debt at floating rates. They love low rates and want the party to continue.  In the other corner, you have a growing number of politicians, economists and savers who see the risks of holding interest rates artificially low as growing by the day. They point to the recent upswing in food and energy prices as evidence that inflation and asset bubbles could be a byproduct of current Fed rate policy.

The first question to answer about this interest rate war is: will this be a political or economic battle? Long-term interest rates are more sensitive to market pricing. This means the politicians and Fed policy-makers can’t control long term rates like they can attempt with shorter rates. Investors, especially foreign investors , with their buying and selling of Treasury bonds, set the tone for long term rates on CDs, mortgages and loans. These investors tend to run to Treasuries as a flight-to-quality when things get topsy-turvy around the world, but could also abandon them if they become too worried about things like the value of the U.S. dollar, ballooning deficits or inflation. This isn’t a wild conspiracy theory. Money has flooded into the U.S. as the world has perceived the dollar as a safe haven for assets. But it’s perception over reality. And long-term interest rates are controlled by that perception and not Keynesian monetary policy.

The Federal Reserve and politicians do have a little more control over short-term rates. The FOMC sets the rates that banks use to borrow against each other or from the discount window. Grand initiatives like QE1 and QE2 can help foster a low-rate environment. And Fed officials can make speeches and testify boldly in front of Congress on that state of the economy and the need for low rates. But at the end of the day, even short-term rates are subject to the buying and selling of U.S. debit in the form of T-bills. Again if investors start selling, rates will push higher. And eventually they will sell. We are not talking a wholesale liquidation of Treasuries by investors. Think of it more like investors sensibly trimming holdings to adjust the risk in their portfolio.  Here’s why it might happen:

1. Oil and inflation

The civil revolutions in the Middle East have spurred higher oil prices due to supply disruptions and higher productions costs, but they truth is that oil was already heading higher. And even though the global dependence on oil is debated by environmentalists endlessly, the truth remains that no other commodity is as important to the global economy as oil. Simply said if oil prices continue to rise, price inflation will follow. To combat inflation, major economies (including the U.S.) will have to increase interest rates.

2. Economics

Low interest rates made perfect sense when the unemployment was at 9.8 percent and GDP in the United States was negative. However, now GDP is pushing higher and labor reports have improved dramatically. By the end of summer, there should be enough job growth and economic activity to make the need for 0% rates hard to justify. The number of economists who have raised their forecasts for interest rates has increase in the last few weeks due to these economic fundamentals.

3. Bank Growth

Banks look at where the Fed sets rates when they set their deposit rates. The prime rate, the federal funds rate, Treasury yields and bank rate averages are all important. But the biggest consideration for a bank is their funding needs. The more banks lend, the more money they need to take in with deposits. And you guessed it, when banks needs deposits – they raise their CD rates. By the end of 2011,  expect enough banks to be in a growth mode again to see a few even raise CD rates to bring in new money to lend. Now that would be a change!

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