A decade ago, deposit rates exhibited a similar pattern of behavior to the cycle we are currently experiencing. Although the actual rates are much lower this time around, the pattern of declining rates followed by a turning point (in August 2003) is identical to the current period, suggesting that financial institutions will experience a higher level of liquidity risk about one year after rates start rising due to deposits gravitating towards shorter-term certificates of deposit (CDs).
In August 2003, rates of all CD terms started rising after reaching their lowest point in that cycle. Short-term CDs of three and six months stood at 0.92% and 1.09% respectively, mid-term CDs of one and two years at 1.25% and 1.66% and long-term instruments of three, four and five years at 2.11%, 2.46% and 2.90%.
From August 2003, CD rates started increasing continuously for exactly four years, reaching their highest point for that cycle in July 2007, which is when they started decreasing in response to the slowdown of the economy and the beginning of the most recent recession of December 2007 to June 2009. Although the last recession was officially declared in December 2007, the actual slowdown in the economy started in June 2007 because it takes two consecutive quarters of negative gross domestic product (GDP) to constitute a recessionary environment.
While rates of all CD terms increased during the cycle of 2003 to 2007, the marginal rate variance among the various CD terms was not uniform throughout the four-year time period of rising rates. In the first year of the cycle, from August 2003 to August 2004, the variance stayed consistent; however, between mid-2004 and mid-2007, we see the rate variance among long-term CDs shrinking, thus making short-term CDs more attractive.
For example, the marginal rate variance between three- and six-month CDs increased from 17 basis points (bps) to 63 bps during the 2003-2007 cycle. Conversely, the variance between the six- and 12-month CDs started at 17 bps on August 2003, peaked at 51 bps in April of 2006 and declined to 32 bps by July of 2007. The variance between 12- and 24-month CDs started at 40 bps, peaked at 62 bps in October 2004 and declined to only 4 bps by July 2007.
The variance between the 24- and 36-month CDs started at 46 bps, peaked at 55 bps in June 2004 and declined to negative 2 bps by July 2007. The variance between 36- and 48-month CDs started at 35 bps, peaked at 38 bps in July 2004 and declined to 4 bps in July 2007. And the variance between 36- and 48-month CDs started at 44 bps, peaked at 46 bps in April 2004 and declined to 14 bps in July 2007.
The implications of this phenomenon are that depositors will prefer to lock in their money for shorter terms if the rate difference between the terms is insignificant. For example, in April 2007, the annual percentage yield (APY) of a two-year CD was 4.20% and 4.18% for a one-year CD, a rate variance of 2 bps. It is very unlikely that depositors will double the term of their CD for a meager 2 bps in interest yield.
As a result of the shrinkage in the yield differentiation between long- and short-term CDs, banks are likely to experience a shift in deposit balances towards short-term CDs and liquid accounts, which is riskier for banks because these balances can be withdrawn more easily than long-term CDs.
Mr. Geller is the executive vice president of San Anselmo, Calif.-based Market Rates Insight, which provides competitive research and analytics to financial institutions. He can be reached at email@example.com.
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