Very briefly: the market.

More broadly: the market’s estimate of inflation over the period of the note combined with the current risk premium over treasuries demanded by the market, minus whatever cut the issuing bank thinks they can get away with taking from you.

It is the market.

For some more details, you will notice (bankrate.com is a good site to check) that higher rates are usually found among smaller institutions.

This is sometimes referred to as a “small bank premium.” They also will often raise their rates more quickly than a large bank.

A lesser-known bank, especially one with fewer branches, will often need to pay more in order to attract deposits. These are also often captive banks that fund credit card operations (like Discover Bank).

See:

http://www.bankrate.com/brm/rate/high_ratehome.asp?params=US,416&product=15

or

http://www.bankrate.com/brm/rate/mmmf_highratehome.asp?params=US,416&product=33

Rates of longer dated CD’s and Bonds are a function of future inflation and economic expectations by the market. Short term rates, including money market rates are far more closely tied to the overnight lending rate (Fed Funds Rate) that banks charge one another in order to meet reserve requirements.

p-dude

I agree with michael, but something is missing here. If a 6 month cd pays 5%, is that mean that annual inflation is about 10% ? If so why reported inflation is about 3% a year ? who is lying here, Government or bond market ?

I never believed reported inflation numbers from government simply because I see inflation on my daily expenses. Form what I see in San Diego it’s about 8% to 10% a year

I tried to rationalize bond market and understanding why would someone put their money in long term treasury when it pays less than short term while dollar is depreciating like Titanic. I read about market expectation, inverted yield curve ,…… bla bla bla. It just doesn’t add up unless we are going back to 1% over night rate and a major recession. If so what is going on with stock market at 13,565 ? Sometimes it feels like living in Matrix.

No matter what the duration of the note the interest rate is quoted annualized. If you buy a $1,000 6 month note at 5% interest you’re going to get back $1,025 after 6 months, not $1,050.

“I tried to rationalize bond market and understanding why would someone put their money in long term treasury when it pays less than short term while dollar is depreciating like Titanic.”

Some market participants don’t care. For example, let’s say I go to an insurance company and buy an annuity. They then take that money and put it into long term bonds and make a spread between what I agreed to accept an what they are earning in the bond market. They don’t care about currency fluctuations since they aren’t converting out of USD when they pay me back. They also don’t care too much about how much more they could be making in a riskier asset such as stocks because they have committed to a fixed payout. If their investments come up short it hurts a lot.

This is called duration matching and it’s a really big part of why wall street securitizes mortgages the way they do (basically the demand from insurance and pension funds for AAA rated long term debt, coupled with the low supply of actual AAA rated long term debt. This creates a price gap that you can make money on if you can come up with a way to create AAA debt out of other things)