Cash isn’t doing you any favors
Forces are colliding to send cash rates even lower, so be wary of how much you’re holding.
Our Top Market Takeaways for February 19, 2021.
Markets in a minute
Interest rates steal the show
Most markets have “embraced the optimism” over the last three months. Recently, sovereign bond yields have joined the party. So far this month, 10-year U.S. Treasury yields have jumped over 20 basis points, and are now at the highest levels since the pandemic began. So why are longer-term rates moving higher, and what does it mean for our outlook and for you? In short, they are moving higher for the right reasons: economic recovery, fiscal stimulus, and Federal Reserve policy. It might take the stock market some time to acclimate to higher rates, but strong earnings growth should win the day. Let’s dig in…
- The simplest explanation for why interest rates are moving higher is that the U.S. economy is healing. Economic data has been surprising to the upside consistently since last summer. The latest example was retail sales, which grew by 5.3% in January, well above economist expectations. It also helps that COVID-19 cases in the United States are down 71% from their peak, and that 16% of U.S. adults have received at least one dose of a vaccine.
- Markets seem to be buying into the idea that additional stimulus spending, coupled with the Federal Reserve’s commitment to getting inflation to average 2% over time, will succeed. Markets expect inflation to average around 2.2% over the next 10 years, up from 2% at the beginning of the year.
- But eventually, the Federal Reserve will start to raise interest rates. Futures markets now suggest two hikes from the Fed in 2023, up from only one in December. Importantly, markets not only expect the rate-hiking cycle to start sooner, but also to go faster as well. The current pricing suggests that the federal funds rate will be close to 1% by the end of 2024.
We often say that credit is like oxygen for the economy. When rates rise, it gets harder for the economy to breathe. But we don’t think this move in rates is close to causing tension in the economy or for the stock market:
- The interest rates that businesses (investment grade and high yield bond yields) and consumers (mortgage rates) face are still low enough to incentivize investment and spending.
- We expect GDP to grow at its fastest pace in over 30 years, and for earnings to grow at their fastest pace since 2010. The risks seem skewed to even further upside.
- Just look at history. During the now infamous “Taper Tantrum” of 2013, 10-year Treasury yields almost doubled after then-Fed Chair Ben Bernanke suggested the Fed was going to start easing off the gas pedal by winding down asset purchases. Meanwhile, the S&P 500 rallied almost 20%.
Bond markets are starting to reflect a world where the pandemic is finally brought under control, where pent-up demand and excess savings drive robust consumer spending, and where once-in-a-generation fiscal stimulus helps drive once-in-a-generation GDP growth. They are embracing the optimism.
But even despite the change in longer term interest rates, short term rates have been going nowhere fast. In fact, we believe the most likely path for cash rates is even lower. How is that even possible?
The game just got even trickier for cash
Aside from modestly increasing inflation, the forces of supply and demand are colliding to push cash rates even lower.
Enter the big players: the Federal Reserve and the Treasury Department. Together, these two account for most of the splashes and waves in the bond market (especially Treasuries), and each are taking steps in 2021 that will flood the financial system with even more liquidity and spell a challenging environment to those clinging to cash.
Let’s examine each.
In corner #1, we have the Fed.
As a quick refresher, the Fed renewed its QE program (among other measures) to combat the COVID-19 crisis and keep the wheels of the economy turning. To do so, the Fed is purchasing huge amounts of government bonds and mortgage-backed securities. As the government buys bonds to inject the financial system with liquidity, prices are driven up and yields are pushed lower.
To date, the Fed is buying $120 billion per month of bonds and mortgage backed-securities, and by most economists’ expectations, this pace will continue into the end of the year. This means the supply of cash from the Fed will keep going up, so the price of cash (the yield) has to go down.
Cue player #2, the Treasury.
Just as we have a checking account at a bank to deposit our paychecks and pay our bills, the U.S. government’s Treasury has one at the Fed (dubbed the Treasury General Account, or TGA). The government uses its checking account for payments (such as for stimulus, or its budget) and deposits (such as from collecting our taxes, or from issuing government bonds, bills and notes).
Each time the Treasury transacts in its account, it creates a ripple effect through the financial system. As the Treasury makes payments from its own account, those funds then flow into banks’ deposit accounts—the money has to go somewhere!
Over the last year, the Treasury has accumulated an unprecedented $1.6 trillion in its account to fight the crisis (talk about saving!), and now it’s looking to spend pretty much all of that down. As a result, all that liquidity will move from being parked in the Treasury’s account at the Fed to the financial system (à la the banks and financial institutions). And as this liquidity floods the financial system (increasing the supply of cash), it also has the effect of pushing cash yields down.
Taken together, these two factors will put even more downward pressure on cash rates, and could send them negative. This means that those holding money market funds or equivalents could actually lose money and be faced with a challenging period ahead.
To be clear, the effects will be felt most profoundly by those holding money market funds or short-term Treasury bills. We don’t think those who hold cash in their good ol’ deposit accounts will see negative rates. Deposit accounts are more likely to charge negative rates when central bank rates also go negative (as they have in Europe). The Fed seems adamantly opposed to negative policy rates.
What can you do about it?
At the risk of sounding like a broken record, be wary of how much cash you’re holding and what vehicles you’re using. Does it align with your goals and your investment strategy?
For those invested in money market funds and short-term Treasury bills, one step investors can take is to shift their cash exposures into slightly longer-dated Treasuries, where we expect yields to remain positive. And for those willing to take on more risk, short-term, high-quality corporate bonds could present an option.
As always, your J.P. Morgan team is here and ready to help you think through your options.
All market and economic data as of February 2021 and sourced from Bloomberg and FactSet unless otherwise stated.
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