Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Wednesday, February 15, 2023
Economists like to remind us there is no such thing as a free lunch. In investment parlance, that just means all investments carry risk—even cash. After last year’s aggressive rate hiking campaign from the Federal Reserve (Fed), short-term interest rates are at levels last seen in 2007. Moreover, due to the elevated fed funds rate and the subsequent carryover into the U.S. Treasury market, the Treasury yield curve is the most inverted since the early 1980s (that is shorter-term Treasury securities out yield longer maturity securities). As seen on the chart below, yields on Treasury securities that mature in one year or less are approaching 5%, which is up significantly since the end of 2021. This has (finally) allowed investors to generate a return on cash—and investors have taken notice. According to ICI, a company that tracks investment flows, nearly $5 trillion is sitting in money market assets, which is double the amount pre-COVID-19. So where is the risk that economist warn us about? The big risk with cash is reinvestment risk. That is, while short-term rates are currently elevated, the risk is that these rates won’t last and upon maturity, investors will have to reinvest proceeds at lower rates.
The Fed continues to fight elevated inflationary pressures by raising short-term interest rates. Over the past 12 months, the Fed has taken its fed funds rate to 4.75% (upper bound), and they may not be done yet either. Markets are currently pricing in at least two more 0.25% rate hikes over the next few months, which would take the rate to 5.25%—the highest level since 2007. The Fed’s goal has been to take the fed funds rate into restrictive territory to make the cost of capital prohibitively expensive to slow aggregate demand, which will allow inflationary pressures to abate. Then what? Well, after winning its fight with inflation, markets expect the Fed to start cutting rates next year. After keeping rates at these elevated levels, the Fed will likely take the fed fund rate back to a more neutral level, which economists believe is 2.5%. Just as the aggressive rate hiking cycle took Treasury yields higher, interest rate cuts will take all Treasury (and other bond market) yields lower—that is when the reinvestment risks of investing in cash will show up.
Below is a simple exercise that looks at the outcomes of an investor who allocates $1,000,000 in cash and then rolls over the investment proceeds at maturity back into cash at the prevailing interest rates, versus investing in a core bond strategy that is yielding 4.6% (which is the current yield on the Bloomberg Aggregate Bond Index). Over shorter horizons, certainly cash is an attractive option, but for investors with a three to five year time horizon, the difference in sticking with cash versus owning intermediate maturity fixed income instruments is pretty meaningful.
While we certainly think cash is a legitimate asset class again, unless investors have short-term income needs, they may be better served by reducing some of their excess cash holdings and by extending the maturity profile of their fixed income portfolio to lock in these higher yields for longer. Bond funds and ETFs that track the Bloomberg Aggregate Index, along with separately managed accounts and laddered portfolios, all represent attractive options that will allow investors to take advantage of these higher rates before they disappear.
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