What will happen to interest rates?
by James L. BotsfordThe Federal Reserve’s recent lowering of the federal funds rate is good news if you are a borrower. If you are a saver, it is a different story.
This most recent rate reduction follows a two-year period when the Fed raised rates at every scheduled meeting and then left them alone from June 2006 until September 2007. Just to refresh your memory, the Fed lowered rates 12 times during 2001 down to 1.75 percent. Of course, those low rates helped to fuel our real estate market as well.
At the other end of the spectrum, go back to 1980 when the federal funds rate peaked at 20 percent. How great it would have been to lock in a Treasury Bond during that period. Conversely, could you imagine paying 18 percent interest on your home mortgage? Lots of people did.
So what can you expect as we head into 2008?
You can turn on the financial news on any day and listen to a wide range of opinion. You hear one expert and think, “Hey, that makes sense.” Then someone else comes appears with a completely opposite view, and you say, “Gee, that guy has a point too.”
The reality is no one knows where rates are heading in the long run. Even the esteemed Bill Gross, who manages more fixed-income investments than anyone on the planet, was dead wrong with his predictions this year.
So now we turn to you, the consumer. You have a Certificate of Deposit that is about to mature. The rate you had was 5.35 percent for a one-year term. Now you’re trying to decide what to do with the money.
Concerned that your new CD rate will be lower, you rush to see your friendly neighborhood banker and learn that the rate on a 6-month CD is actually better than the rate on a 5-year CD at 5 percent versus 4.75 percent.
What the heck is going on? Well, back in February 2005 then Fed Chairman Alan Greenspan referred to this as the “interest-rate conundrum,” the oddity of longer rates being lower than short-term rates. This conundrum has improved only slightly since then, as yields on short-term fixed-income investments are essentially on par with the yields on long-term fixed-income investments.
The reality is that most investors recently have chosen to park their money in the short-term CD option and then revisit it at maturity six months or a year later.
Seems logical. But what if rates drop more?
There is a time-tested strategy for investors that helps even out the movements in interest rates over time – it’s called laddering.
Let’s suppose you have $250,000 to invest and you are looking for safe fixed-income options only. Using the laddering technique, you would divide the money into five $50,000 pots and invest each pot in one-year increments up to five years.
Using this approach, you would have funds coming due annually that you will reinvest, keeping the ladder intact. Let’s suppose that rates have risen over the last year. You’re a happy camper because you can reinvest that $50,000 pot at a rate that is higher than it was a year earlier.
Now let’s suppose the opposite. Rates have fallen over the past year. You’re at least a comfortable camper, thinking, “At least I still have 80 percent of my money invested at higher rates than the current environment.”
By using this strategy of laddering you also remove the emotional aspect of the decision about what to do with your maturing investment. Incidentally, this strategy isn’t limited to CDs. It can be easily implemented using bonds as well.
Establishing this type of discipline, no matter what it is in life, is a healthy thing to do. The reality is no one really knows where rates are headed over the longer term – despite what they might tell you on television.
James Botsford is a vice president and certified financial planner with Cape Cod Five Cents Savings Bank's Trust and Asset Management Group. He can be reached at jbotsford@capecodfive.com.
Published in Cape Business November/December 2007
James L. Botsford James L. Botsford, CFP, is vice president of Cape Cod Five Trust and Asset Management. 
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