Yield Curve of American Certificates of Deposit Viera MALACKÁ Abstract In 1961, in the USA were issued the first negotiable certificates of deposit (CDs). Securities dealers created the secondary market for these securities and certificates of deposit became highly liquid instruments. Certificates of deposit are a part of the primary sources of commercial banks. An issue of certificates of deposit can be quick because of banks need to obtain new resources. CDs also offer banks the opportunity to limit the interest rate risk arising from an imbalance between interest-sensitive assets and liabilities and prevent decline in profit. This paper aims to highlight the importance of certificates of deposit and points out that the yield curve of American certificates of deposit is a reliable indicator of the beginning of the economic recession. Key words Certificates of deposit, interest rates of CDs JEL Classification G1, G2 Introduction A reason of a new bank product - certificates of deposit was long-term decline in bank deposits in the USA. The largest corporate clients reduced their deposits in banks and focused on the purchase of Treasury bills, repurchase agreements and other money market instruments. The aim of the product was to obtain lost deposits back into the banking system. Certificates of deposit sharply increased the average cost of funds of US commercial banks. The decision of banks to offer a new money market instrument was difficult. The banks had two alternatives - to face billions in losses or offer a new tool. In the time of the bankruptcy of Penn Central Transportation Company in 1970, the money market was considerably shaken. The Federal Reserve stopped applied interest rate caps for the large short-term certificates of deposit (30-89-day). Three years later was abolished interest rate caps also for the long-term certificates of deposit. Was a sharp increase in the volume of large certificates of deposit, especially in a period of rapid economic growth.
In the country of their formation can be certificates of deposits issued in registered on a name or a deliver. CDs on the deliver are more negotiable on the secondary market. The nominal value of traditional certificates of deposit is from 25 thousand to 10 million USD, but money market instruments have for a minimum nominal value of 100 thousand USD. Maturity is usually 1-12 months according to client needs. Transferable certificates of deposit generally have shorter maturities, within six months. Certificates of deposit with a maturity of 12 months in the United States are known as the termed CDs. The origin deposit protection scheme in the US guaranteed the payment of certificates of deposit if a bankruptcy of the issuer - the bank up to 100 thousand USD. In 2008, this amount was increased to 250 thousand USD in response to the loss of customer confidence to outbreaks of the financial crisis. Increased deposit protection should prevent massive deposit withdrawals and strengthen the stability of the financial system. Investors hold certificates of deposit to maturity. Active trading in the secondary market in New York includes quality certificates of deposit especially major banks. Those interested in certificates of deposit are mainly large corporations seeking to increase liquidity, or investors aiming shorter maturities, respectively higher yields in comparison with new issues of CDs. US banks are prohibited from buying their own certificates of deposit on the secondary market, and also redeem them before maturity. "Certificates of deposit are the money market instrument that is a short-term segment of the financial market. On the market collects offer and demand of short-term capital, with a maturity of a year. Huge pace of innovation did not go around certificates of deposit, therefore arose certificates of deposit with maturities over a year." [5] The market of CDs in the United States is among the most advanced and most widespread markets CDs in the world in volume and diversity. The article is therefore devoted the market with certificates of deposit in the USA. The aim of this article is to emphasize the importance of certificates of deposit as a money market instrument with high liquidity and to determine whether an inverse yield curve of certificates of deposit in the United States was an indicator of economic recessions. 1 Literature Review The market of CDs quickly spread also to Europe. "The market with certificates of deposit meant also the beginning of dollar certificates of deposit in 1966. The first sterling certificate of deposit was traded in 1968 when foreign banks, some commercial banks and banking
houses began to issue and hold certificates of deposit. In 1971, other banks quickly joined, including the clearing banks. During the 70s of the 20th century, the market was booming." [3] Commercial banks and other depository institutions use certificates of deposit, if need additional reserves as a supplement to loans in the interbank market. A deposit institution that needs funds simply raises interest rates of current certificates of deposit, to attract new deposits. For obtain the necessary funds, financial institutions can also trade with certificates of deposit on the secondary market (not their own certificates). Similarly can, if cash requirements, sell Treasury bills. Currently, negotiable certificates of deposit have an important role in the management strategies liabilities when banks control sources of their funds, as well as the use of these resources to permit achieving all the objectives. "[8] Certificates of deposit followed up on used banking techniques and forms used during the collecting of deposits. Thanks to these securities, these forms improved even further and especially standardized. Banks located in the United States managed to overcome some regulatory restrictions of banking laws through the certificates of deposit, regarding to interest rates and made an attractive product of money market. [6] Characteristics of types and innovation of CDs can differ to a small extent, as well as the characteristics of CDs in different countries. Professional literature brings different characteristics of certificates of deposit. The literature essentially defines these securities in the same way: "Certificate of deposit is a money market instrument, a product of commercial banks or other financial institutions. Certificate of deposit can be characterised as a kind of security that is a confirmation of the issuer (the bank) about receipt of one-time deposit at par value that is indicated thereon. Certificate of deposit is a product containing elements of debentures (debt instrument) and deposit of money. The time of maturity of the securities is not limited by law. [4] "Certificate of deposit is a security that confirms the acceptance of one-time deposit of issuer (bank) rounded amount of money in nominal value indicated on thereon as of deposit. The bank as the issuer of the certificate of deposit undertakes to release the deposit within the time and pay the owner interest rates. Certificates of deposit are issued each bank or financial institution. Certificates of deposit allow obtaining primary sources of banks in the money market. Certificate of deposit is a product that focuses characteristic bond (debt instrument)
and cash. Certificates of deposit can generally have different forms and conditions, in practice specific countries down detailed rules for emissions trading and acceptable treatment certificates of deposit." [2] "Certificates of deposit are securities that in materialized form confirm the acceptance of the term deposit. For the bank it is extremely stable sources, because the bank all times pays the nominal value after the expiry of the agreed period. From the perspective of the client, certificates are an interested product with high liquidity capability. In banking practice, we meet with this form of the acquisition of deposits with a maturity of 1-2 years, but usually for a period till a year. Certificates of deposit are designed for a wider public having an advantaged interest rate, resp. various events with a draw." [1] "Certificate of deposit is a certificate of bank that confirms a receipt of rounded deposit generally on a short-term to medium-term maturity. The issuing bank undertakes in the certificate to pay the nominal value in due time and pay interest rates to the holder of certificate. The interest rate is agreed concerning to the time for which the bank has the deposit available. [6] Certificates of deposit are worldwide known by the acronym CD (Certificate of Deposit), it is the confirmations with interest rate about deposit funds in the banks or in other depository institutions on a precise period. Banks issue them with a goal to obtain short-term and medium-term free cash, and this from inhabitants but also from business subjects and large investors. For clients, CDs are an alternative of term bank deposits. Certificates of deposit are more preferred for banks because of the client can t ask for their payment before maturity date. [7] 2 Certificates of deposit a part of the primary sources of commercial banks Certificate of deposit is for the bank an alternative to the different kinds of deposits. By gathering these resources, banks try to overcome certain regulatory restrictions and increase liquidity. Banks acquire stable sources by issuing of certificates of deposit, as many banks do not allow early repayment of the nominal value. Certificate of deposit is actually a kind of primary deposit of banks. Legislation of countries relating to the incorporation of certificates of deposit to the basis for calculating of the required minimum reserves is not uniform. Banks offer a wide range of deposit certificates to a wide range of public. They are offered to subjects interested in banking products, but also thanks to various nominal values and
maturity, to a wide range of investors. Certificates of deposit are for investor a tool for shortterm, respectively medium-term investing of money. The indisputable advantage of American certificates of deposit is an option to sell them on the secondary market, if necessary of funds. Liquidity CDs is thus ensured by their negotiability. Comparing certificates of deposit and term deposit we find some important differences. "CD is unlike a term deposit freely transferable. This means that the owner can freely sold it or given away without the knowledge of the bank. Some banks, however, restrict the transferability of DC. If the issuance CD as materialized securities, is responsible for the loss, theft or destruction owner, who thus loses the right to receive payment of nominal value. Banks therefore offer the possibility to impose physical securities for safekeeping. Unlike term deposits, banks issue CDs with accurately determined at face value. On average, these values are multiples of 1000 monetary units of the currency. This may be in some sense a disadvantage compared to traditional term deposits. Certificates have a fixed maturity from a few months to a year. CDs can be also issued with longer maturities. Most CDs can t be terminated before maturity. However, CDs that the bank shall adopt before the end of their maturity, but usually with significantly reduced interest rate, respectively at the cost of high fees." [5] Deposits to CDs usually have higher yields than traditional term deposits. Return from the CD is also a standard higher than the yield on Treasury bills. This is due to lower liquidity CD, a higher risk of the issuer and tax revenues. The health of the banking system in the country and the phase of the economic cycle produce an effect on the spread between the yield on Treasury bills and CDs. The yield therefore depends on the interbank market, and liquidity of the issuer of certificates of deposit. Less stable banks must issue CDs with higher return. 3 Yield curve of certificates of deposit in the USA When analyzing the yield curve of CDs in the United States, we assumed that the inverted yield curve prevented the recession, as witnessed history in many American crisis. If CDs have the inverted yield curve, the interest rate of an instrument with shorter maturities is greater than the interest rates of the same instrument with longer maturities. In the market is a negative sentiment regarding the long-term interest rates and are expected their decline. Inverted yield curve is actually an indicator that represents a reversal of the economic cycle. Effect of inverted yield curve occurs mainly in investing in instruments with fixed interest rate. In standard conditions are short-term financial instruments linked to lower yields than
1965-12-01 1967-05-01 1968-10-01 1970-03-01 1971-08-01 1973-01-01 1974-06-01 1975-11-01 1977-04-01 1978-09-01 1980-02-01 1981-07-01 1982-12-01 1984-05-01 1985-10-01 1987-03-01 1988-08-01 1990-01-01 1991-06-01 1992-11-01 1994-04-01 1995-09-01 1997-02-01 1998-07-01 1999-12-01 2001-05-01 2002-10-01 2004-03-01 2005-08-01 2007-01-01 2008-06-01 2009-11-01 2011-04-01 2012-09-01 the long-term instruments. With increasing maturity of investment increases the investor's risk and shall be reflected as a higher risk premium. Inverted yield curve eliminates the effect just mentioned that short-term financial instruments have a higher yield than the long-term instruments. In practice it means, the long-term securities have a similar yield as a short-term paper, e.g. 10-year government bonds and the 6-month certificates of deposit. This fact confirms the long-term yield curve that compares interest rates of 6-month CDs and 10-year government bonds in the US from 1965 to 2013. During the nearly 50 years in the development of interest rates occurred several years, when interest rates had an inverted yield curve and short-term 6-month DC offer a higher yield than the 10-year government bonds. Specifically, it was the years 1981, 1989, 1999, 2000 and most recently in 2007. The inverted yield curve also confirmed the change in the economic cycle in the 2007 (Figure 1). Figure 1: Interest rates of 6M CDs and 10Y US bonds 20 15 10 5 0 10Y bonds- 6M CDs 10Y bonds 6M CDs Source: own processing according to the Federal Reserve Bank of St. Louis The same conclusion also follows from the analysis of the yield curves of the same financial instrument - certificates of deposits with different maturities. For comparisons were selected interest rates of 1-, 3- and 6-month certificates of deposit on the secondary market in the same period, t. j. from 1965-2013. Negative values were calculated as the spread among the 3- and -month and 1-month CDs. Negative values of spreads for each year of the period under review shows that interest rates of 1-month CDs were above the interest rates of 3- and 6- month CDs.
24077 24504 24929 25355 25781 26207 26634 27061 27485 27912 28338 28764 29190 29618 30042 30468 30895 31321 31747 32174 32599 33025 33451 33878 34304 34731 35156 35582 36008 36434 36861 37288 37712 38139 38565 38991 39417 39845 40269 40695 41122 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Figure 2: Inverse yield curve of US 1M, 3M and 6M CDs 5 % 17 % 12 % 7 % 2 % -3 % -8 % 4 % 3 % 2 % 1 % 0 % -1 % -2 % 1M CDs 3M CDs 6M CDs Source: own processing according to the Federal Reserve Bank of St. Louis This fact confirmed the existence of an inverse yield curve and also the existence of a recession economy (Figure 2). To confirm the inverse yield curve as an indicator of reversal of the economic cycle was used also the analysis of interest rates of 3-month CDs and Treasury bills with identical maturities - Figure 3: Interest rates of 3-month CDs and 3-month Treasury bills 20 18 16 14 12 10 8 6 4 2 0 CDs - TBills 3M TBills 3M CDs Source: own processing according to the Federal Reserve Bank of St. Louis
3-month Treasury bills in the period 1965-2013 (secondary market). For comparisons were therefore selected financial instruments with the same maturity but with different degree of risk. Throughout the period under review was the return on Treasury bills lower than the return of CDs. This fact may because of more developed secondary market for Treasury bills and also because of the risk premium of CDs. The biggest spreads in the yield of these securities were recorded during the economic recession in the oil price shocks and in 2007-2008, associated with the beginning of the current financial crisis. In the secondary market, the interest rates of CDs recorded values several times higher than was the level of interest rates on Treasury bills (Figure 3). "The movement of interest rates on the market of the short-term and long-term instruments is primarily influenced by the economic cycle itself. Movement of interest rates follows the economic cycle. This means that in times of economic boom interest rates tend to rise, on the contrary, in times of recession interest rates fall." [5] Issuers and financial institutions adapt to this and offer cheaper funds. During the recession, the Fed implements expansionary monetary policy that is enhanced by a decline in market interest rates. To assess the dependence of interest rates and GDP development were selected interest rates of 6-month CDs on the secondary market and nominal GDP over the period 1965-2011 (Figure 4). Figure 4: Interest rates of 6-month CDs and nominal GDP 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% 6M CDs nominal GDP Source: own processing according to the Federal Reserve Bank of St. Louis The development of interest rates 6-month CDs and nominal GDP confirms that short-term interest rates of CDs follow the economic cycle with some delay and their response to changes in GDP occurs within the time horizon of 1-3 years later.
The formation of a secondary market for CDs accelerated growth of CDs in circulation and increased the use of CDs as a money market instrument. The role of the secondary market was to provide CDs with shorter maturities as compared with the primary market CDs. Both markets, primary and secondary market with CDs are closely linked. Dealers as intermediaries trade with CDs at interest rates that reflect current market conditions. Dealers buy CDs from either the original owners or directly from issuers. Sometimes CDs get to the market through brokers and the so-called resale to the dealer through a third party. The last way is limited. On the other hand, dealers sell CDs to various corporations, trusts, institutional investors, but also issuers CDs. The issuers buy their own CDs or invest in CDs of other issuers. Banks make use of this investment if the interest rate of CDs is higher of interest rates of other financial instruments. CDs do not provide the same degree of liquidity. Banks also help their clients to sell CDs at good prices to potential customers or other customers. Figure 5 shows the evolution of interest rates US primary and secondary market CDs. If interest rates decrease, the yield curve of the primary and secondary market is similar and approaching to each other. The opposite is if rates grow. If rates rise, interest rates on the secondary market CDs rise faster than those in the primary market CDs. When interest rates decline, investors assume further decline, causing a rise in demand of current CDs, especially in the secondary market. Price DC is the inverse function of the interest rate, therefore, at higher demand for DC on the secondary market, the price of CD increases and interest rate decreases. Figure 5: 6M CDs on US primary and secondary market 12,00 10,00 8,00 6,00 4,00 Secon.m. Prim.m. 2,00 0,00 Source: own processing according to the Federal Reserve Bank of St. Louis
It approximates the interest rates on the primary market CDs. Conversely, when an uptrend yield curve, their prices fall and interest rates on the secondary market with CDs increase above the level of interest rates on the primary market. The yield curve of 6M CDs on the primary and secondary market from 1984 to 2010 confirms that the interest rates on the secondary market with CDs are higher than the interest rates on the primary market. The exception is 1986, when it was opposite. Conclusions We concluded that in the country of origin, the certificates of deposit are popular securities used for investment. The analysis of interest rates CDs confirmed that the yield curve CDs is a reliable indicator of the beginning of the economic recession. It happened in the 70s at the time of the oil shocks, in the Dot.com crisis and also in the current financial crisis. We found that nominal GDP influenced the level of interest rates, but with a certain time lag. Primary market of certificates of deposit was copied secondary market. The next conclusion of the paper is that the Treasury bills on the secondary market during the period had lower interest rates than CDs on the secondary market. Risk margin increased during the economic recession and decreased during expansion. The paper is the result of the project implementation VEGA (1/0124/14) The role of financial institutions and capital market in solving problems of the debt crisis in Europe. Ing. Viera Malacká, PhD. Department of Banking and International Finance Faculty of National Economy University of Economics in Bratislava Dolnozemská cesta 1 852 35 Bratislava Slovakia Sources: [1] BELÁS, J. a kol., 2007: Manažment komerčnej banky. Trenčín: GC-TECH Ing. Peter Gerši, s. 183, ISBN 80-225-1618-X,
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