Investor Considerations: Interest Rates and Money Markets
March 10, 2023:
Inflation and interest rate movements continue to be the primary focus for investors as they keep a close eye on both the equity and fixed income markets. In fact, the headlines have remained relatively focused on these two pieces of data since the end of 2021. But what does the movement in rate and inflation numbers mean for the average investor, and the average saver?
As a refresher, one of the Federal Reserve’s primary tools to combat high inflation is to raise their benchmark interest rate. Raising this rate serves to limit access to credit thereby slowing economic activity. For example, if interest rates on home improvement loans are relatively high, homeowners are less likely to proceed with projects such as large renovations, additions, and upgrades. With the many inputs going into these jobs, it is easy to see in just this one example how raising interest rates can certainly slow down consumer and corporate spending, hiring, etc. Since the beginning of 2022, the Federal Reserve has raised its benchmark rate aggressively. At the time of this writing, the range of the Fed Funds rate, the rate that influences household lending on mortgages, loans, and savings rates, is now 4.50% – 4.75%.
One of the silver linings to the rise in short-term interest rates is that now cash/money market can be looked at as an asset class again, with investors being rewarded for cash savings. For the last decade money market funds had paid virtually zero in interest, pushing investor fund flows towards riskier asset classes for returns, including equities and high yielding credit. Many among the new crop of young investors are seeing a return in their savings and money market accounts for the first time in their adult lives.
Given the rise in money market yields, broader benchmark treasury rates, and the current shape of the yield curve, we wanted to address some common questions and perspectives regarding rates and strategy.
Q: If short-term interest rates and money market rates have risen to +4%, why hasn’t my bank increased their savings rates to around 4%?
A: The primary reason any financial institution is going to raise their savings rate is to attract new customers. When Covid-19 first swept the globe and there was a large amount of uncertainty regarding the economy, banks built up cash reserves in order to withstand any resulting economic fallout. After Monetary and Fiscal policies prevented any such prolonged economic fallout, banks and consumers were left flush with liquidity. As a result, banks have not needed to raise the rates they are paying to their customers to attract new customers. Recall that banks earn their returns primarily through the spread they earn on long-term loans vs. the payments to customers on short-term rates – so banks will lag and avoid raising their savings rates until they absolutely must attract new customers. Online banks with lower fixed costs and less overhead will be more competitive in raising their rates on deposits compared with the larger institutions.
Q: What are money market funds? Are all money market funds the same?
A: Money market funds are ultra short-term investments that are considered cash equivalents. These ultra-short funds are invested in securities such as treasury repurchase agreements, treasury bills and commercial paper (for non-government funds). The funds seek to maintain a NAV/per share of $1.00, and while considered cash equivalents, these are NOT insured by the FDIC.
There are many types of money market funds. As with any investment, it is essential to understand the particulars of the funds that you hold. The goal of every money market fund is to maintain a NAV (or share price) of $1.00. However, unless the money market fund is a U.S. Government Money Market Fund, the money market funds may impose redemption fees and redemption gates to prevent runs in periods of extreme financial stress. These regulations were enacted in response to the ’07-’08 Financial Crisis. Funds that have these redemption fee and gate features are often referred to as ‘Prime’ money market funds and may invest in short-term securities outside of government securities. In contrast, government money market funds typically do not have these features and may only opt in to do so if disclosed in the fund prospectus.
Q: Based off the relationship between short-term and long-term rates, why wouldn’t I just keep my fixed income allocation 100% money market?
A: As of the end of February 2023, the relationship between short-term and long-term treasury yields were as follows:
Looking at the Treasury Yield Curve as illustrated above, it is clear that the 6-month bill is the highest yielding part of the curve. The shape of the yield curve often is warning sign that a recession is coming. History tells us that when the Federal Reserve has engaged in a rate hiking cycle, they have gone too far and ultimately have had to cut interest rates during a recession. The shape of the yield curve suggests this is the type of rate environment that the market is pricing in.
This is relevant because it provides insight as to why it may be prudent for an investor to have a portion of the portfolio in bonds or bond funds beyond that highest yielding 6-month point. In 2022, investors were reminded of interest-rate risk and how far a bond portfolio can drop in price from a sharp rise in rates:
Investors that had reached for yield by buying long-term bonds felt this the most. The opposite of interest-rate risk is reinvestment risk, which is the risk that future cash flows will need to be reinvested in lower-yielding securities; this is currently a challenge investors are faced with when positioning portfolios in 2023. Rates have felt tremendous upward pressure over the last year, and will continue to face upward pressure should inflation prints and economic data continue to come in higher than expected. At some point, however, rates may fall, and an investor who has just simply been rolling short-term maturities would not have locked in any higher yields for a longer horizon.
The rate outlook will likely continue to cause volatility in equity and fixed income markets, but it is exciting that investors can expect to earn yields in money markets and fixed income again. If the Fed’s forecasts come to fruition, it is likely that rates will be elevated for a period of time over the next few years. Please feel free to reach out to us with any questions or concerns regarding the rates being earned in within your Centerpoint Advisors, LLC managed accounts, or if you would like to discuss offers you are seeing at your local bank. We are here.