Interest Rates - How Low Can They Go?
UPDATE: On Aug 9, the 5-year Treasury broke the one percent barrier and closed yielding 0.91 percent. Rates plummeted upon the downgrade of US Treasury Securities. Mortgage rates typically move in the same direction as intermediate and long-term Treasuries.
In early May, Wells Fargo's chief economist, Johan Silva, told me interest rates were definitely going to rise this year. He said it's just a matter of how much. He stated that his estimate was that the 5-year Treasury rate was going to increase by 0.30 to 0.50 percentage points. Since making that confident forecast on May 5th, the 5-year Treasury actually declined by 0.71 percentage points, dropping from 1.95 percent to 1.24 percent. How low can they go? I have the answer as well as what you should do with your cash in the mean time.
5 year Treasury
Since 1962, the 5-year Treasury rate has ranged from a high of 16.27 percent during the inflationary days in September of 1981, to an all time low of 1.04 percent in November of 2010. Thus we have yet to hit an all-time low.
In 2006, rates were over five percent. Many economists predicted rates would rise, as the inverted yield curve couldn't last. They were dead wrong. Rates have steadily fallen to the modern day low levels of the past year.
King cash
When markets tanked in 2008 and 2009, investors ran to cash, though sprinted was more like it. Investors feared that rising rates would cause a bond bubble, so many avoided bonds. Both stocks and bonds rallied, though King Cash retained its throne as many were still too scared of bubbles.
How low?
How low can the 5-year Treasury rate go? The answer, to state the obvious, is that it can only lower by 1.24 percentage points since that would bring it to a big fat zero yield. I'm not saying it will go that low, but I'm betting that rates won't turn negative on a nominal basis. Those who might disagree with my premise should ask themselves if they would lend $100 for the promise of being paid back $99 in a year. That's one of those propositions unlikely to have any takers.
I ran my theory by advisor and author William Bernstein who pointed out they could go slightly negative, since Treasuries have a bit of a storage and security premium that makes them preferable to stuffing the cash inside your mattress.
What to do now
Allow me to reiterate that I'm not claiming to know what will happen to intermediate to long-term rates. There is certainly more downside to rising rates than there is upside, given this zero absolute bottom. So cash is guaranteed to lose and bonds are very risky.
The answer is simple. You can earn intermediate-term rates without the risk by buying CDs that have easy early withdrawal penalties. My favorite two are:
- Allly Bank 5-Year CD paying 2.32% APY with a 60 day early withdrawal penalty.
- Security Service Federal Credit Union 7-Year CD paying as much as 3.50% APY with a 1-year early withdrawal penalty.
Each pays nearly 2-3 times the 5-year Treasury rate. If rates do shoot up, pay the early withdrawal penalty and put your money into something paying more.
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