Last year many economists were predicting a Fed rate hike in June. They were off by six months. The Fed rate hike finally came, but it wasn’t until December. There are two things to note from this. First, it’s very difficult to predict interest rate changes. Second, there has been a long history of delayed rate hikes. It’s a good idea to remember these two things when thinking about your strategy with the money you want to keep in deposit accounts.
The difficult question for 2016 is how fast will the Fed increase rates. The Fed has made it clear that they’re planning only "gradual increases in the federal funds rate," and this depends on the economy improving as they expect. Fed officials have suggested that gradual means around four 0.25% rate hikes this year.
Based on minutes of December’s FOMC meeting, the Fed may be more gradual than this. As economist Tim Duy mentioned in his Fed Watch blog regarding the minutes, "the inflation situation is making FOMC members nervous and thus holding them back from a more aggressive path of rate hikes." Higher inflation will depend on improvements in the job market, and that is showing signs of improvement. The December employment report that was just released was strong. That increases the chance of four Fed rate hikes this year, which is probably the best case scenario for savers.
In a rising interest rate environment, it’s tempting to disregard long-term CDs. No one wants to be locked into low rates as interest rates rise. The alternative is to keep your money in savings accounts and short-term CDs. You can benefit more quickly when interest rates rise, but you lose out while you wait for higher rates. Since rate hikes will likely be only gradual at best, I don’t think it’s wise to give up on long-term CDs. CD ladders still make sense. Below are two CD ladder strategies that can help you deal with a rising rate environment. I described these two strategies last year, and I think they still make sense today.
Standard CD Ladder with Mild Early Withdrawal Penalties
If you want to keep things simple, stick with a standard CD ladder. With a standard CD ladder, you don’t have to guess about how fast rates will rise.
If you want to ease worries about being stuck in a long-term CD as rates rise, look for CDs with mild early withdrawal penalties (EWP). I consider a mild EWP to be no more than six months of interest for a 5-year CD. You can compare the effective yields of CDs after the early withdrawal penalties by using our CD early withdrawal penalty calculator. Be aware that there are risks on depending on an early closure of a CD ( see article).
Barbell CD Ladder with Internet Savings Accounts and/or Reward Checking Accounts
If you don’t feel comfortable with long-term CDs as interest rates slowly increase, you may want to consider a barbell CD ladder. In this approach about half of the deposit accounts are in long-term CDs and the other half are in online savings accounts and/or reward checking accounts. Short-term CDs are typically used instead of liquid accounts in a barbell CD ladder, but since short-term CD rates are so low, I think internet savings accounts and/or reward checking accounts make more sense. The exception would be when you can find good short-term CD deals (like the 12-month CD deal at XCEL Federal Credit Union).
The more you keep in internet savings accounts and reward checking accounts, the more work will be required. Reward checking accounts offer the best rates, but these require a lot of debit card purchases. And since all have balance caps, you may need multiple reward checking accounts. Even if you find an internet savings account or a reward checking account with a top rate, it doesn’t mean it’ll last. Be prepared to move that money when the bank cuts the rate and/or balance cap. Very few banks remain rate leaders over the long run.
If you’re trying to find the best mix of CDs, savings accounts and reward checking accounts, give this tool a try. The tool is called "Where to (Safely) Grow Your Cash". You enter your state, your savings amount and your saving timeframe. The tool will then provide several options that include CDs, savings accounts, reward checking accounts, and various combinations of all three. You’ll have to decide on the best one for your needs. That will depend on factors like your need for liquidity and your amount of effort.
As you think about tweaking your CD ladder strategy, it’s important to remember the two points that I mentioned at the beginning. It’s very hard to predict future interest rates, and rate hikes may take longer than you expect. Long-term CDs look less appealing with rising rates, but they can still be good deals if you look at the alternatives. That doesn’t mean you should keep everything in long-term CDs, but it may not be wise to keep everything in savings accounts. The right mix can be the best option.