Posted on: Sunday, April 25, 2004

Savers are about to get lucky — but strategy needed to rise with rates

By John Waggoner
USA Today

Some people haven't trusted the stock market since 1929, and they don't think much of the bond market, either. For them, the only real investment is one that's 100 percent guaranteed.

But the past few years have been perfectly miserable for savers. The fed funds rate, a key overnight interest rate, is at levels last seen at John F. Kennedy's inaugural. But better days are ahead.

Economists say savings rates could rise in the next 12 months — perhaps sharply. The trick is getting the highest rates without locking in at the wrong time.

Savings rates typically follow short-term interest rates, which are controlled by the Federal Reserve. When the economy looks shaky, the Fed lowers interest rates, making it easier to borrow. When the economy looks like it's growing too quickly, the Fed raises rates.

Until recently, the Fed was worried that the nation would fall into deflation — a downward spiral of prices. So it slashed the fed funds rate from 6.5 percent to 1 percent in 2000.

Savers took the brunt of those cuts. The average money market mutual fund yields 0.51 percent, which means a $100,000 account would earn just $510 a year. Savers in money funds lost more to inflation than they earned in interest.

Most economists agree that the Fed will raise interest rates to more normal levels soon. David Wyss, chief economist for Standard & Poor's, thinks the Fed will start pushing up rates at the June meeting of its powerful Federal Open Market Committee.

"March was a near blowout" for the economy, Wyss says, and the Fed will move quickly to keep the economy from overheating. Pimco's McCulley thinks the Fed won't start to ratchet up rates until August, in part to make sure unemployment starts to fall.

How high will rates go? "Ultimately, the Fed's target has to be 4 percent to 4.5 percent," says Mark Zandi, chief economist for Economy.com. That's the high end. S&P's Wyss guesses 3.5 percent. Typically, the fed funds rate is about 1.5 percent above the core inflation rate.

But "the Fed won't have an itchy trigger finger," McCulley says. Like most economists, he thinks the Fed will proceed cautiously, raising rates by a quarter of a percentage point at a time.

Given a gradual rise in rates, savers should use three strategies:

• Increase money fund holdings. True, they don't yield much now. But money fund yields typically rise quicker than bank CDs. "Keep your powder dry until the Fed raises rates," McCulley says. If the Fed raises more than expected, you'll have a good opportunity to lock in higher rates than with a bank CD.

Two tips: Choose a money fund with low expenses. When rates are this low, giving away half a percentage point can slash your return in half. And tax-free money funds currently yield an average 0.50 percent — virtually the same as taxable funds. Most people will earn more after taxes in a tax-free fund.

• Stagger maturities. Even the best Fed watchers don't know when rates will rise. If you need higher rates than offered by a money market fund, you'll need to invest in bank CDs or Treasury bills. Divide your cash into quarters and purchase a 12-month CD or one-year T-bill every three months. If rates rise, you'll be investing — and reinvesting — at higher rates.

A tip: Choose the highest-yielding CD, even if it's not offered by a bank in your area. The average one-year CD yields 1.69 percent, says Bankrate.com. The current high-yielder, from Corus Bank in Chicago, yields 2.27 percent.

• Ladder maturities. If you must invest now, consider buying a mix of six-month, one-year and three-year CDs. If rates rise, you'll be able to roll your short-term CDs into ones with higher yields.