The Federal Reserve’s fastest and biggest campaign to raise interest rates, which began in early 2022, lifted returns on money market funds and other money-like investments north of 5%. For investors buffeted by volatile stock and bond markets, it’s hard to resist cash.
“Clients have loved it this year,” says Rebecca Boyd, wealth adviser at Frost Investment Services. “I think there’s more money on the sidelines now than we’ve ever had.”
Reflecting U.S. investor sentiment for 2023, there were net outflows of $131.9 billion from U.S. equity funds and inflows of $895.1 billion into U.S. money market funds during the same period, according to LSEG Data & Analytics. Total assets of money market funds reached $5.9 trillion in the week ended Dec. 6, a 24 percent increase from the end of 2022, according to the Investment Company Institute.
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Because the yield curve is inverted and longer-dated bonds pay less than shorter-dated bonds, investors don’t have much incentive to go further out on the maturity spectrum. They can get better returns at the short end with little interest rate risk.
Yet now that the Federal Reserve has suggested in its last announcement of 2023 that it expects to begin cutting rates next year, cash will cease to be gold.
There are several reasons why staying cash will cost you. For starters, having your money in cash instead of bonds means you’ll miss out on capital gains when interest rates fall, pushing bond prices up. The second is reinvestment risk, the risk that you will have to reinvest a maturing short-term security at a lower rate in the future. But the biggest reason for long-term investors is that bond yields tend to outpace cash yields over long periods of time.
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“Cash is not the most important thing for medium- or long-term investors,” says Adam Hetts, global head of multi-assets at Janus Henderson. “Money is always a necessary evil for very short-term needs. But for longer-term needs, longer than 1-2 years, this is where you can use a longer-term fixed income.
Even if you think the economy is going into recession tomorrow and you put all your cash into a 5% yield, you probably won’t beat a balanced 60/40 portfolio of stocks and bonds. Historically, cash has returned just half of what a typical 60/40 portfolio would have returned from the start of a recession through the 12 months of the recovery, according to Hetts’ analysis. “There’s a huge cost to being in cash,” he says.
The likelihood that cash will outperform bonds with longer durations decreases as an investor’s time horizon increases. And since interest rates peaked — where we seem to be right now — cash has tended to lag longer-dated Treasuries, according to Vanguard.
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“The longer the time frame you’re moving out, historically, the more likely cash is to underperform long-term bonds, and the rate of underperformance is greater,” says Chris Tidmore, senior manager at Vanguard’s investment advisor research center.
Food clues
Bernstein Private Wealth Management found that yields start to decline about 6 to 9 months before the Fed actually cuts rates. “If you believe us that the Federal Reserve will cut interest rates for the first time in the summer of 2024, back up 9 months…and you would have exited the money markets a few months ago,” said Matthew Palazzolo, senior investment strategist at Bernstein Management of private wealth.
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Another reason to leave money behind is reinvestment risk, which is more of a risk now than it was six, nine or 12 months ago, Palazzolo says. “We had a clear view then that the Fed would keep interest rates at these higher levels for a sufficient period of time,” he says. As we head into 2024, the evidence that the economy is slowing is more evident and the risk that the Fed will start cutting rates is now greater.
“The reinvestment risk for investors working in cash-like products is certainly real and part of the reason why we advocate moving out of cash and into medium-term bonds,” he says.
For the short term
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Of course, holding cash is important for short-term needs—emergencies, unplanned expenses, upcoming college tuition bills. Boyd says. Frost advises clients to limit cash to 3% to 5% of their portfolio unless they are in the distribution phase of retirement, in which case that range may be higher.
Kathy Carey, director of research at Baird’s Private Wealth Management group, says the firm typically recommends about 2% to 3% of a portfolio in cash. At least for now, the shorter end of the yield curve is still higher than 10-year bonds, so “I don’t think there should be a crazy bump from short-dated instruments,” Carey says.
Moving excess money
Palazzolo recommends that clients first reallocate any excess cash into their long-term strategic allocation. But for those hesitant to invest in stocks before an economic slowdown, he says moving further down the risk spectrum into bonds, specifically high-grade intermediate-duration fixed income that yields 4% or more high is a reasonable approach.
“There is potential to collect that yield next year, but also to capitalize if yields fall and prices rise,” he says. “We think it’s likely that high-quality bond investors will again benefit from money market funds in 2024, after doing so in 2023.”
For investors sitting on cash, waiting for the Fed to cut interest rates and then trying to pivot back into longer-duration bonds usually doesn’t work.
“If you wait for the Fed to cut rates, you’re missing out on most of the return,” Hetts says.
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