How Inflation Affects Money Market Funds
The stock market hasn’t brought much joy, bonds have been a source of considerable pain, and inflation is worrying.
But finally, there’s a glimmer of good news for people who need a place to park their money: money market mutual funds are finally starting to pay some interest.
These funds are a convenient place for individual investors and large institutions to temporarily hold cash. Their returns have been very low for years, and since the March 2020 crisis, they have hovered around zero, paying investors virtually nothing.
But now that the Federal Reserve has begun to raise the short-term interest rates it directly controls, the yields on money market funds available to consumers have also begun to rise – and they will continue to rise as long as the Fed will continue to raise short-term interest rates. – forward rates.
“You can expect money market rates to continue to rise for some time,” said Doug Spratly, who leads the cash management team at T. Rowe Price. “And they will increase quite quickly.”
Don’t get too excited just yet. This is not a throwback to the early 1980s, when the money market rates climbed above 15 percent, with the inflation rate. The yield of a large average money market fund is still only around 0.6%, said Peter G. Crane, president of Crane data of Westborough, Massachusetts, which oversees money market funds.
“Yields are moving in the right direction,” Crane said. “But that’s not much, especially when you take inflation into account.”
The latest Consumer Price Index figures released on Friday showed inflation hit an annual rate of 8.6% in May, creating a huge gap between inflation and money market yields. It’s not good for your personal wealth, to say the least. On the contrary, it indicates that your inflation-adjusted real rate of return is deeply negative. In other words, the longer you keep your cash in a money market fund, the less buying power you will have.
The role of the Fed
Money market yields won’t stay where they are for very long. On Wednesday, the Federal Reserve is expected to raise rates again, and money market rates are expected to follow, with a lag of about a month.
How this happens is a bit complicated, so bear with me for a quick dive into the financial plumbing.
Understanding inflation and its impact on you
What will catch the most attention on Thursday is that the Fed will raise the key federal funds rate, probably by 0.5 percentage points, to a range of 1.25 to 1.50%. In July, this should happen again, with more increases to come. Traders are betting that the fed funds rate will exceed 3% in 2023.
But the Fed also raised other interest rates, including one with a dismal name: the repurchase agreementaka the reverse repo rate.
This rate stands at 0.80% but was close to the zero limit for months. Money market mutual funds receive this rate for funds held by the Fed overnight, so it functions as a rough floor on returns.
Currently, short-term treasury bills, with yields in the range of 0.85-1.05%, are a practical ceiling, especially for funds that hold government securities.
As I wrote when interest rates fell to near zero in 2020, the operating expenses of money market funds exceeded the income they brought in. This meant, theoretically, that the funds could have used negative returns to make money, resulting in fund investors paying for the privilege of putting their money in a money market fund. Negative rates have not occurred in the United States. Fund companies have provided spending waivers — in effect, grants — to keep the funds operating.
Rising short-term interest rates mitigated this particular crisis. How money market fund rates move depends on the arc of inflation and the Federal Reserve’s response to it.
A place for money
In practice, in today’s volatile markets, many people need good places to hold their money for the short term. In the past, I’ve noted that several options — like bank accounts and treasury bills — sounded reasonable. Now, I would add money market funds to that list, with some caveats.
Be aware that, returns aside, money market funds have encountered security problems during the last two financial crises. Since then, they have been subject to stricter regulatory control and a series of reforms.
Many funds now only hold US government securities, and all are required to hold only high-quality debt securities. All are intended to avoid fluctuations in value, even if they have been put to the test before and may well do so again. In any case, money market funds are safer than bond or stock mutual funds or exchange-traded funds.
I asked Mr. Crane, who has watched money market funds closely for decades, if he would recommend them.
“At this point, I think they’re as secure as anything,” he said, but added that bank accounts with government insurance “have a slight security edge.” Still, he said, if we ever get “into a situation where monetary funds lose a lot of value, you’ll have a lot of other issues to worry about, like finding your waders and making sure you have enough food. canned”.
What is Inflation? Inflation is a loss of purchasing power over time, which means your dollar won’t go as far tomorrow as it did today. It is usually expressed as the annual change in prices of common goods and services such as food, furniture, clothing, transport and toys.
I would put it this way: the chances of losing money in a money market fund are low. In another major financial crisis, it is quite possible that they will run into problems again, but the government has always stepped in to solve them.
There are other options for holding short-term money securely. In short, they include US Government Bonds I, which yield an incredible 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 purchase, but there are also small penalties if you collect them before five years.
Bank accounts are extremely safe, although the interest most pay is very low. A investigation by Bankrate.com found that the average return on savings accounts in the United States was just 0.07%. Some online bank accounts have higher rates given; in some cases they are around 1%. Short-term bank certificates of deposit, treasury bills and high-quality short-term corporate bonds are also available. All of these rates are on the rise.
The yields paid by money market funds are currently lower than those of treasury bills and corporate bonds or commercial paper, but with fluctuating rates the funds have a big advantage. The fund manager can trade higher interest treasury bills or commercial paper as they become available. I’m not ready to spend time doing this myself. I prefer to let a fund manager do the work for me.
As usual, Vanguard’s fund expenses are low, which improves fund returns: The Vanguard Federal Money Market Fund has a yield of 0.72 percent. The T. Rowe Price Cash Reserve Fund, which Mr Spratley manages, is close, at 0.66%. The Fidelity Money Market Fund has a yield of 0.60%. Virtually all major asset managers offer money market funds.
Once you start watching them, you will find that the returns increase steadily.
Who knows where they will be next week? It’s almost exciting.
When rates fall again
Remember, however, that these returns are still extremely low. They’re not tracking inflation, and if they end up doing that, that’s probably not good news either.
Imagine that in the not too distant future, the Federal Reserve manages to reduce the rate of inflation close to its target rate of 2%. To do so, however, it slows the economy down, possibly even tipping it into a recession. This is no reason to rejoice.
But as soon as a slowdown is evident, the Fed is likely to start cutting rates, creating an opportunity for nimble money market fund managers. They can extend the duration of their holdings so that returns delay the decline in money market yields for up to two months. You could then beat inflation, but only by a small amount. And with a slowing economy, you’ll have plenty of other things to worry about.
For now, try to enjoy the spectacle of rising money market rates without falling into what US economist Irving Fisher has called “the illusion of money.“Remember that in real terms, you are losing money.
Yields on money market funds are improving, yes, but as an investment they are still a bad idea.