KEY TAKEAWAYS
- A silver lining of higher inflation has been the increase of interest rates earned on cash savings
- These higher interest rates bring back some previously popular savings options such as money market accounts, CDs, and Treasuries
- Your advisor can assist you with developing a solid cash management plan to fit your specific needs
As part of the financial planning process, all good advisors advocate for the importance of keeping cash for significant short-term expenses and unexpected life events. Since the “Great Recession” that occurred between 2007-2009 (aka the Global Financial Crisis), the options for how to invest this bucket were uninspiring, forcing clients to choose between simply receiving little or no return for their ultra-safe investments or taking more risk than warranted to get some return.
How it Happened
The economic recovery coming out of the Great Recession was one of the slowest on record. Consumers worked to repair their balance sheets. The overbuild in housing during the mid-2000s meant that new construction, a leading driver of U.S. economic growth, came to a near-standstill. New banking regulations resulted in less lending to fund new investments. The economy was hungover after the debt-fueled party of the prior decade.
Slower growth meant low inflation, and this caused (and allowed) the Federal Reserve to keep interest rates at historic lows for much of the decade. One of the goals of its stimulative efforts was to incentivize investors to take more risk. Since interest rates were low, yields on cash were almost nonexistent, forcing investors to move further out on the risk spectrum to get a return on their money. Bonds were the new cash, stocks were the new bonds, and private equity/venture capital became a common way to allocate to capital markets. The moniker TINA (There Is No Alternative) sprouted in this environment.
What’s Changed in 2022?
Inflation. Lots of it.
The highest level of inflation in 40 years. There are many causes, including pandemic-era fiscal spending and monetary stimulus, disruptions in supply chains due to COVID-19 and the Russian invasion of Ukraine, and evolving spending habits from consumers. Inflation has been widespread and remains significantly elevated after peaking at over 9% in the middle of 2022.
The Federal Reserve has a couple tools to fight inflation. Their main weapon is to increase their benchmark interest rate. This has a ripple effect for other interest rates in the economy. When the price of money goes up, the hurdle rate to make new investments goes up as well. Lower investment results in slower growth and lower demand for goods, services, and labor. The Fed has been very clear; it would like to see the economy slow down, perhaps even enter a recession, in order to significantly lower inflation.
Four consecutive 0.75% interest rate increases have taken short-term rates from 0% to over 3%.
The speed of the hikes has been the fastest in history and brought the Fed’s target rate to the highest level since 2008.
Cash Funds for Emergencies and Short-Term Expenses
One of the key tenets of a good financial plan is the creation and maintenance of an emergency fund. This is simply cash set aside for life’s unexpected events. This money allows you to pay bills without incurring debt or having to sell assets that are designed for longer-term purposes, potentially incurring losses along the way. Having an emergency fund will be especially important if the Federal Reserve gets the economic slowdown that it is trying to engineer. The amount of cash needed is usually calculated as a number of months (usually 3-6) of living expenses. The number of months the emergency fund covers is unique to each individual, and now is a great time to review upcoming significant expenditures over the next 1 or 2 years. Make sure to work with your financial advisor to determine what is best for you.
Over the past decade, cash savings have dragged down overall portfolio performance as cash earned close to 0%. And now, thanks to higher interest rates from the Federal Reserve, cash is yielding more than longer-duration bonds and U.S. stock dividends.
There are many options for investing the cash you have set aside. Bank savings rates have not kept up with the rise in market interest rates, so there may be better options available. Options include:
- Money Market Funds: A money market fund is a kind of mutual fund that invests in highly liquid, short-term instruments. These instruments include cash, cash equivalents, and highly rated debt securities with short-term maturities (such as U.S. Treasury Bills). Money market funds are intended to offer investors high liquidity with a very low risk to principal.
- Certificates of Deposit: A certificate of deposit (CD) is a savings product that earns interest on a lump sum for a fixed period of time. CDs differ from savings accounts because the money must remain untouched for the entirety of their term or risk penalty fees or lost interest. CDs usually have higher interest rates than savings accounts as an incentive for lost liquidity.
- Treasury Bills: T bills are short-term government debt obligations. They have the benefit of being back by the U.S. government and are short-term in nature, so they are less influenced by interest rate changes. Current yields on these ultra-safe bills are the highest they’ve been in over a decade.
- Series I Bonds: Issued by the US government, series I savings bonds protect you from inflation. Owners of I bonds earn both a fixed rate of interest and a rate that changes with inflation. The inflation rate is set twice a year for the following six months. I bonds can only be purchased through the US government and there are limits on how much each investor can invest in any given year.
- Short Term Bonds/Bond Funds: Another option is to buy a high-quality, short-duration mutual fund or exchange traded fund (ETF). These have fallen in price over the past twelve months and are now providing reasonable yields. The value of these funds will fluctuate daily depending on changes in interest rates, but the very short-term nature of them will limit any drawdowns.
Over the past decade, efforts to maximize one’s returns on cash have generally been ineffective as all options essentially paid nothing. Investors responded by accepting little to no return or investing their emergency fund in riskier assets. As interest rates rise, it is important that you reassess your cash positions with your financial advisor to ensure you are making the best use of what the market has to offer. Cash management should be a part of every financial plan, and with more attractive options now available, cash can play a larger role in your overall plan.
To discuss cash management strategies with a SageView financial advisor, please click here.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
An investment in a money market fund is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve your $1.00 per share, it is possible to lose money in the fund.
The return and principal value of bonds fluctuate with changes in market conditions. If bonds are not held to maturity, they may be worth more or less than their original value.
Mutual funds and Exchange-Traded Funds are sold only by prospectus. Investors should consider the investment objectives, risks and charges and expenses of the funds carefully before investing. The prospectus contains this and other information about the funds. Contact your financial professional at 800-814-8742 to obtain a prospectus, which should be read carefully before investing or sending money.