Money Markets are a Way to Generate Cash Again

The era of cheap money has ended. The ten rate hikes since 2022 have made capital expensive again resulting in slowed growth across businesses.

This pain is not confined to the corporate world. Most Americans are also feeling the pinch as the financing cost of major purchases continues to rise.

There’s Good News to be Found in Money Markets

These hikes aren’t all bad news. Money market funds, which closely follow the Fed funds rate, are starting to deliver respectable yields.

At the start of 2022 money market rates were close to 0% and have since risen to about 4.8%. Today, the highest-yielding money market funds are offering more than 5% interest. This attractive yield explains why money market assets have surged from $5.2 trillion to $5.6 trillion since the end of 2021.

Put simply, money markets look good again. In fact, they look much better than most of the other places savers park their money. As a result, “deposits will continue to shift into higher rate categories that are more responsive to monetary policy” according to an analysis from the Federal Reserve Bank of New York. This makes sense given that deposit rates usually lag changes in the fed funds rate, especially in an environment of rising interest rates.  

The researchers examined how quickly banks have been passing on central bank base interest rate increases on to their depositors, a measure called “deposit beta.” They explain that “the spread between the fed funds rate and the deposit rate is at a modern high of above 2 percent.” Anyone committed to the adage “follow the money” is likely headed for a money market fund right now.

Source: New York Fed

Yields Are Up, But What About the Risks?

Money markets not only offer strong yields, they also offer a high degree of safety given that, “investors have never had major losses in money market funds in the United States” according to the Wall Street Journal.

A closer look reveals just how uncommon losses are. Consider that in the more than 50 years that money markets have existed, they have “broken the buck” only twice. Research from Vanguard shows that the first of these two instances occurred in 1994 when the Community Bankers U.S. Government Money Market Fund made the bad decision to hold 43% of its assets in risky derivatives ultimately leading the fund to liquidate at 94 cents per share.

The second was in 2008 when the Reserve Primary Fund saw its net asset value drop to 97 cents per share due to debt securities it held issued by Lehman Brothers Holdings. This second failure was enough to prompt the SEC to amend its rules in 2014 making money markets safer. Specifically, the new regulations stated that money market funds could “no longer be allowed to use the special pricing and valuation conventions that currently permit them to maintain a constant share price of $1.00.” Additionally, the regulations initiated “enhanced diversification, disclosure and stress testing requirements.”

The low risk of money markets also comes from their investments in Fed repurchase agreements which are very safe because they are an overnight lending arrangement with the Federal Reserve. As Nafis Smith, principal and head of Vanguard’s taxable money markets, explains, “in a rising interest rate environment like the one we’re experiencing, any repurchase agreements are very good at dampening market volatility because they allow us to increase stability by reducing interest rate risk. Repurchase agreements also allow us to pass along the higher interest rate to investors much more quickly.”

How Long Will Fed Rates Remain High?

Strong money market yields will only last if the Fed continues to keep rates high. Therefore, the question is, how long will Fed rates remain elevated?

Unfortunately, there is no way to answer this question definitively. However, the CME Fed Watch Tool offers some clues. The site analyzes “the probabilities of changes to the Fed rate and U.S. monetary policy, as implied by 30-Day Fed Funds futures pricing data.”

Today, the data suggests that by December 13th, 2023, rates are likely to fall between 4.25% and 4.50%.

Fast forward to January 31st of 2024 and the picture starts to change. By that point the data forecasts that rates will most likely be between 4.00% and 4.25%. By May 1st of 2024 rates are expected to be even lower, between 3.50 and 3.75%.

The data indicates that now is the time for investors to take advantage of high yields in money market funds.

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