Cash has been king for the past two years, the first time in decades. Money markets, CDs, Treasury Bills, and high-yield savings accounts now yield more than 5%. In the decade following the financial crisis, earning meaningful interest on cash savings was an increasingly distant memory. For the past two years, earning a competitive, guaranteed return on a low-volatility investment has been quite attractive, especially with geopolitical tensions flaring and volatility in equity and fixed-income markets. From the end of 2021 through May 1, 2024, the Schwab Value Advantage Money Fund, a money market fund offered at Charles Schwab, had a total return of 8.50% compared to 9.24% for the S&P 500 and -10.89% for the Bloomberg U.S. Agg Total Return Index. But cash may not be king for much longer.
In December 2023, the Federal Reserve announced they were holding the Federal Funds Rate steady between 5.25% and 5.50%. Despite holding rates steady, they communicated their intention to cut interest rates three times by 0.25% per cut in 2024. Markets took this narrative and ran with it, perhaps a little too far too fast. Financial markets began pricing in six rate cuts at the start of 2024. In January and February, inflation data came in higher than anticipated, and the market dialed back expectations, falling in line with the Fed signaling of 3 cuts. When March inflation data also came in higher than anticipated, the market dialed back expectations even further, with an average expectation of 1.6 rate cuts for 2024. Despite reduced expectations, one thing is clear: the Fed will be cutting rates at some point in the not-so-distant future. For investors who have been holding cash and cash-like instruments, this means that the return on their cash holdings is set to decline, as the rates paid out by high-yield savings accounts, money market accounts, and short-term interest-bearing instruments tend to follow the direction of the Federal Funds Rate.
As cash returns are set to drop, one of the beneficiaries will be fixed-income. Bond prices have an inverse relationship with interest rates; that is, as rates rise, bond prices fall, and as rates fall, bond prices rise. Voya Investment Management published the below chart, showing the hypothetical risk versus reward trade-off from fixed-income at current rates:
As the chart shows, there may be more upside potential than downside risk in the fixed-income market at current interest rate levels, given the hypothetical interest rate movements. While it is certainly not guaranteed that outcomes will reflect exactly what is shown in the chart, the risk versus reward profile of fixed-income at the moment appears to be skewed more positively than it has been in years.
Also, as the Fed cuts rates, short-term yields will drop faster than long-term yields, as short-term yields are driven more by monetary policy than yields further out on the interest rate curve. So, short-term, cash-like instruments will see yields fall faster when the Fed begins cutting rates than longer-term fixed-income instruments. Because of reinvestment risk, investors may benefit from moving cash into fixed-income before the Fed begins its rate-cutting campaign. As a bond comes due, the rate at which the proceeds are reinvested may differ. If a short-term instrument comes due after the Fed begins its rate-cutting cycle, there is a real chance that you will not be able to reinvest the proceeds at the higher yields available today. In short, waiting until the Fed begins cutting rates to move out of cash means the opportunity to lock in high rates for a longer period may also have passed. On top of yield, fixed-income securities generally also buffer equity volatility. Per Voya, over the last 50 years, bonds have helped to offset negative equity returns in years where equities had a negative return. 2022 was one of a few exceptions to this, but we do not expect the next equity market pullback to be similar to 2022. On top of that, Voya also noted that bond returns have averaged about 1.5x that of cash returns over the past 40 years. Additionally, looking at rolling 5-year periods from 1986 to 2022 bonds have outperformed cash 98% of the time.
With the most attractive rates seen in years, a resilient economy, and the Federal Reserve looking for the right time to adopt less restrictive policies, fixed-income managers create a robust backdrop to drive total returns. It may be time to consider putting cash to work in a bond market rich with opportunities.
