Rather watch Ara explain the market commentary in a video? Click here to watch.
The phrase “cash is king” seems to be losing some of its luster after dominating headlines in 2022 and 2023. As addressed in my January commentary, while there are no guarantees, interest rates are likely to decrease further over the coming years. The rate and pace will largely depend on the health of the U.S. labor market and economy, which lately have been showing some signs of cooling.
While the 10-year U.S. Treasury yield has significantly declined from a year ago, it remains at a robust ~4%. Ironically, the amount held in money markets and CDs (at U.S banks) continues to swell to over $9 trillion. This leads to the question of why. If interest rates are likely to decline further, why do consumers continue to plow money into these cash-like equivalents?
YIELDS
Most CD and money market yields are higher than the current annual inflation rate of 2.4%. For some, earning a positive net inflation-adjusted return with no principal risk is an attractive tradeoff. It should be noted that while money market yields can change at any time, they generally reset a few times every year. This means their rates tend to lag versus CDs, which reset immediately upon maturity.
With the recent decrease in inflation, CDs and money markets seem like a no-brainer, as many are currently yielding 1% to 2% above inflation. On the surface, this is a match made in heaven. While this spread won’t last forever, it can be hard to pass up. The longer-term issue at play is reinvestment risk. As seen in the chart below, history shows that CDs generally do not keep pace with inflation over the long term.
REINVESTMENT RISK
Reinvestment risk stems from the risk that an investor will not be able to reinvest funds from an investment at the same or a higher rate than current. Let’s look at an example:
Tom purchased a one-year CD at 5.5% in September of 2023. Upon its maturity, Tom decided to renew but was notified that rates had dropped to 4%. Tom’s average return over the two years was ~4.75%. What if Tom renewed one more time but this time at 3.25%? Tom’s average return over the three years would be ~4.25%. While nothing to sneeze at, it is far below the 5.5% earned in year one. This decrease in rates equates to Tom’s reinvestment risk.*
While this may not seem like a sizable difference, it adds up over time. As seen on the chart below, the Fed’s federal funds rate target is to be below 3% come 2026. If this plays out, rates on cash-like equivalents would likely be cut in half from their highs in Q4 of 2023. This would amount to a significant level of reinvestment risk for years to come.
Of course, as we know, the Fed has been known to change course often, so there’s no assurance that things will play out exactly as planned. With that said, it seems like rates will continue to drift lower over the coming years.
It should be noted that reinvestment risk can also be your friend. In the example above, if rates were to rise over the coming years, Tom would benefit by reinvesting his CD proceeds at a higher rate. This is pretty much what transpired from Q4 of 2021 to Q4 of 2023.
BONDS
This leads to the question of what one should do. The answer comes back to my old friend, diversification. Having money allocated between some combination of short-, intermediate-, and long-term-duration investments is likely your best bet, as trying to time interest rate moves and bond market reactions is not advisable.
If one believes rates will decline significantly, an overweight in both intermediate- and long-term durations makes sense. On the other hand, if rates decline gradually, then short duration becomes a more attractive option. The rationale concerns duration, which I have written about here. In short, bonds with long durations tend to outperform when interest rates fall, and vice versa.
As seen on the chart above, most bonds currently exhibit a 4% to 4.9% yield to worst. While these yields are presently on par with most CDs and money markets, the interest rate on these bonds is “fixed” over a longer period, which makes them more attractive in a decreasing interest rate environment.
While interest rates are likely to drift lower in the coming years, that does not equate to smooth sailing. There will be volatility and periods where interest rates spike, which can be somewhat offset with proper diversification. One thing does seem certain: Cash is no longer the only king.
Discuss your situation with a fee-only financial advisor.
While bonds can offer stability, they carry the risk of principal loss and may fluctuate with market conditions. This commentary is for informational purposes only and does not constitute financial or investment advice. Individual circumstances may vary.
*The scenario presented is hypothetical and may not reflect actual outcomes. Rates and market conditions are subject to change.