Telemus Weekly Market Review November 14th - November 18th, 2022
A positive ramification from rising inflation is that investors are now able to earn respectable amounts of interest on their cash balances. What’s deceiving is the rate you earn on that cash could be dramatically different depending on where your cash is stored. Those holding their cash in a bank savings (money market) account earn, on average, a rate of 0.96%. That rate compares to government money market mutual funds, which presently pay around 2.0% per annum depending on the fund. What’s unique in this environment is that short-term Treasury bonds offer much higher yields as a 3-month Treasury bond currently sits at a yield to maturity of 4.23%. It is unusual for Treasuries to offer such meaningfully better rates of interest than other cash options.
The wide dispersion of cash interest rates is a function of the cadence of four consecutive 0.75% interest rate increases by the Federal Reserve. These unprecedented actions alongside a Fed that has become more transparent about its future actions has resulted in Treasury yields rising ahead the federal funds rate, which is the interest rate mechanism the Federal Reserve controls. Because of this dynamic, short-term funding options such as overnight lending among banks and overnight repurchase agreements (institutions borrowing against Treasury bonds) presently occur at rates below that of short-term Treasuries. This is at odds with typical norms where overnight lending rates and short-term Treasuries tend to pay similar levels of interest.
This dynamic begs the question of whether investors should consider doing something different with their cash than they have in the past. As with most financial decisions, the answer depends on your goals and objectives. One can buy short-term Treasuries, such as three- or six-month maturities, and earn an annualized interest rate currently north of 4%. While these instruments are very liquid, they are subject to market movements and over the duration of investment there could be periods where they are priced at an unrealized loss. Therefore, purchasing short-dated Treasuries is an attractive option but only for investors that don’t expect to have a need of that cash prior to the bond’s maturity.
Alternatively, government money market funds, which hold short-term Treasury and government sponsored mortgage-backed securities offer better yields than most banks, however, they remain below Treasuries. There are a couple of reasons for this. First, government money market funds have considerable investments in overnight repurchase agreements, or overnight loans backed by Treasury bonds. Overnight repurchase agreement rates tend to track the federal funds rate, which is set by the Fed, and presently sits at 3.83%. It is expected to rise by 0.50-0.75% in December at the Fed’s next meeting. Another component in the shortfall of money market fund rates is funds have been purchasing bonds throughout the year as rates have been rising. Therefore, bonds purchased a few months back presently pay rates below what newly issued bonds pay today. As these older bonds mature, the money market funds will be able to reinvest the proceeds at prevailing interest rates. Thus, there is lag effect with money market funds that we expect to compress toward rates paid on short-term Treasury bonds over time.
Lastly, for banks, the level of interest paid on cash deposits often lags in a rising interest rate environment. Banks need to balance the need for customer deposits while not paying excess rates to maintain those deposits. Due to the high savings rate during the pandemic, banks currently have significantly more deposits than they need. Therefore, they would seem comfortable not being as competitive with deposit pricing. According to the New York Federal Reserve, historically deposits have tracked anywhere between 20% and 60% of the movement in the federal funds rate. This dynamic often leads to bank deposit rates lagging rates paid on money market mutual funds. In a rising rate environment, we recommend investors discuss with their banker their current interest rate and if they are other account types that might offer higher interest rates. Compared with Treasuries and money market funds, banks do offer FDIC insurance on deposits up to $250,000, which for some investors is an attractive benefit.
Given the pace and magnitude of interest rate increases in 2022, one should be cognizant of what they are earning on their cash deposits. Investors have several options but must balance their desire to have access to the entire balance on a daily basis with the prospect that holding individual bonds can add yield but risk encountering short-term movements in the value of their cash. If you want to discuss your cash needs more, please reach out. We’d enjoy assisting you in evaluating your options and guide you toward the best solution.
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