How inflation affects money market funds

How inflation affects money market funds

The stock market has not been a source of much joy, bonds have been a source of significant pain and inflation is a concern.

But finally, there’s a glimmer of good news for people who need a place to park their money: Money market funds are finally starting to pay a little interest.

These funds are a convenient place to temporarily hold money for both individual investors and large institutions. Their yields have been very low for years, and since the March 2020 crisis, they’ve hovered near zero, paying investors virtually nothing.

But now that the Federal Reserve has started raising short-term interest rates, which it directly controls, money market fund yields available to consumers have also started to rise — and they will continue to rise as long as the Fed stays short increased forward rates.

“You can expect money market rates to keep going up for a while longer,” said Doug Spratley, head of the cash management team at T. Rowe Price. “And they’re going to go up pretty quickly.”

Don’t get too excited just yet. This is not a return to the early 1980s, when money market rates rose above 15 percent along with inflation. The return on the average big money market fund is still only about 0.6 percent, said Peter G. Crane, president of Crane Data in Westborough, Mass., which oversees money market funds.

“Revenues are moving in the right direction,” said Mr. Crane. “But that’s still not a lot, especially when you factor in inflation.”

The consumer price index has been at an annual rate of over 8 percent for years, creating a huge gap between inflation and money market returns. That’s not good for your personal fortune, to say the least. On the contrary, it indicates that your real rate of return is heavily negative when adjusted for inflation. In other words, the longer you hold your excess cash in a money market fund, the less purchasing power you have.

Money market yields will not stay where they are for long. On Thursday, the US Federal Reserve is expected to hike rates again, with money market rates likely to follow with a delay of about a month.

How this is done is a little tricky, so bear with me for a quick dive into the financial setup.

What will draw most attention on Thursday is that the Fed is expected to raise the federal funds rate benchmark by 0.5 percentage point to a range of 1.25 to 1.50 percent. This is expected to happen again in July, with more increases to come. Traders are betting the federal funds rate will rise over 3 percent in 2023.

But the Fed has also raised other interest rates, including one with a sinister name: the reverse repurchase agreement, also known as the reverse repo rate.

That rate is 0.80 percent, but has been near zero for months. Money market mutual funds earn this rate on money held by the Fed overnight, so it acts as a rough floor for returns.

Currently, short-term Treasury bills with yields in the 0.85 to 1.05 percent range provide a practical ceiling, particularly for funds holding government bonds.

As I wrote, when interest rates fell to near zero in 2020, money market funds’ operating costs exceeded the income they brought in. Theoretically, this meant that the funds could resort to paying negative returns to make money, which would have resulted in fund investors paying for the privilege of being able to park their money in a money market fund. There were no negative interest rates in the United States. Fund companies waived expenses – effectively subsidies – to keep the funds afloat.

The rise in short-term interest rates has mitigated this particular crisis. Where money market fund rates go from here depends on the inflation curve and the Federal Reserve’s response to it.

In practice, in the currently troubled markets, many people need good places to store their short-term cash. In the past, I’ve found that several options — like bank accounts and Treasury bills — seemed reasonable. Now I would add money market funds to this list with some caveats.

Be aware that aside from returns, money market funds have had some safety issues in the last two financial crises. Since then, they have been subjected to stricter regulatory scrutiny and a series of reforms.

Many funds now only hold US Treasuries, and all are only required to hold high quality debt. Everyone should avoid fluctuations in value, although they have come under pressure before and could do so again. In any case, money market funds are safer than bond or stock funds or exchange-traded funds.

I asked Mr. Crane, who has closely watched money market funds for decades, if he recommended them.

“At this point, I think they’re as secure as almost anything,” he said, but added that bank accounts with government insurance “have a slight security advantage.” Still, he said, if we’re ever “in a situation where funds go down in value, you’re going to have a lot of other issues to worry about, like finding your hip waders and making sure you have enough canned food.” to have”.

I would put it this way: the probability of losing money on a money market fund is slim. In another major financial crisis, it’s entirely possible they’ll run into problems again, but the government has always stepped in to fix them.

There are other ways to keep short-term money safe. In short, they include US Treasuries that yield a staggering 9.62 percent, a rate that resets every six months. They are very safe but imperfect, especially for short-term purposes. Not only are there limits on the amounts you can buy, but there are also small penalties if you redeem them five years ago.

Bank accounts are extremely safe, even if most interest rates are very low. A survey found that the average return on savings accounts in the United States was just 0.07 percent. Some online bank accounts have higher returns; in some cases they are around 1 percent. Short-dated bank certificates of deposit, treasury bills and high-quality short-dated corporate bonds are also available. All of these rates are increasing.

The yields money market funds currently pay are lower than Treasury bills and corporate bonds or commercial paper, but when interest rates are fluctuating, the funds have a major advantage. The fund manager may exchange higher yielding Treasury bills or commercial paper as they become available. I’m not willing to spend the time doing this myself. I prefer to let a fund manager do the work for me.

Vanguard’s fund expenses are low, as usual, which improves the fund’s return: The Vanguard Federal Money Market Fund has a return of 0.72 percent. The T. Rowe Price Cash Reserves Fund, which Mr. Spratley manages, is close at 0.66 percent. The Fidelity Money Market Fund has a yield of 0.60 percent. Almost all major asset managers offer money market funds.

Once you start looking at them, you’ll find that the returns are increasing regularly.

Who knows where they will be next week? It’s almost exciting.

However, keep in mind that these yields are still extremely low. They’re not keeping up with inflation, and if they do, that’s probably not good news either.

Imagine that in the not too distant future the US Federal Reserve manages to bring inflation close to its target rate of 2 percent. In return, however, it will slow down the economy and perhaps even plunge it into a recession. That’s no reason to celebrate.

But once a slowdown begins to emerge, the Fed will likely start cutting rates, creating an opportunity for nimble money market fund managers. They can lengthen the duration of their holdings so that yields lag the fall in money market yields by up to two months. You could then beat inflation, but only by a small amount. And with a slowing economy, you have many other things to worry about.

For now, try to enjoy the spectacle of rising money market rates without becoming a victim of what the American economist Irving Fisher called “the money illusion.” Don’t forget that you are actually losing money.

Money market fund returns are improving, yes, but they remain a bad idea as an investment.

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