As of May 25th, Money Market Funds can be purchased with yields of 5%; 3-month CDs and T-Bills can be purchased to yield 5.3%. What a deal! This is great news for savers and risk-averse investors. (It’s bad news for banks losing demand deposits to these higher-yielding cash equivalents, but’s that another story for another day.)
We can thank the US Federal Reserve Bank (“Fed”) for high yields on cash equivalents. Yields on cash equivalents and short-term lending rates take their cue from the Fed Funds Rate, an overnight, interbank lending rate, set by the Fed. The Fed manipulates this rate to either stimulate or suppress economic growth.
Cash is Currently Sitting Comfortably on its Throne
Prior to 2022, “cash is trash” was a long-standing mantra, going back to the ’07-09 Credit Crisis. In less than two years, the Fed slashed the Fed Funds Rate from 5.25% to 0% and kept it there for years. The Fed attempted to normalize the Fed Funds Rate during ’16-19 but took it right back down in response to COVID-19 and kept it at 0% until 2022. In just over a year, to combat inflation, the Fed has hiked the Fed Funds Rate to 5-5.25% currently! Can you say economic slowdown this way cometh?!
Cash is currently sitting comfortably on its throne: high-relative return and little-to-no risk. Well, not exactly. The risk of holding too much cash for too long in the current environment is a type of risk called, “reinvestment risk.” This is the risk that future returns will be lower because of declining interest rates. Consider a short-term CD. “Rolling” a maturing CD into a new CD is void of reinvestment risk so long as rates continue to rise. The opposite will be true when, not if, short-term rates eventually decline.
Make Your Money Work Harder
I should point out that quoted yields on fixed-income securities, like CDs and bonds, are annualized. The actual return on a fixed-income security with a maturity less than a year will be less. These annualized yields assume that you can reinvest the interest and maturity proceeds at the same yield – that’s a big if.
There’s another consideration: opportunity cost. What are you potentially giving up by not investing in something else? According to financial research and data firm, Ibbotson Associates, T-Bills generated compounded annual returns of 3.2% from 1/1/1926-12/31/2022. That’s barely higher than the average inflation rate of 2.9% over the same period. Investors who have a long investment time horizon should resist the urge to stay too safe for too long. Make your money work harder.
About the Author
Bill McCollum is an investment advisor representative with Eagle Financial, a Wealthcare company. Investment advice offered through Wealthcare Advisory Partners, LLC, (“WCAP”). WCAP is a Registered Investment Advisor with the U.S. Securities and Exchange Commission. Investing involves risk, including potential loss of principal involved. Past performance is not a reliable indicator of future results. Not all strategies are suitable for all investors.