While stocks and bonds have zigged and zagged, often painfully, over the last few years, one area of the markets has been blissfully steady: money market funds.
For more than a year, with minimal risk, investors have been able to get more than 5 percent annually — and substantially beat inflation — by just parking their cash in fairly reliable places.
This wonderful refuge from the market storms isn’t disappearing. But with short-term interest rates likely to fall soon, the shelter will become less comfortable, and it’s time to get ready.
It may be wise to start looking beyond money market funds, locking in the relatively high rates now for at least some of your money, and re-evaluating your needs.
Can you afford to move some of the cash that you don’t need immediately into bonds, which fluctuate in value yet tend to produce better long-term returns than money market funds? And do you have excess cash that may be better invested in stocks, which are likely to produce superior long-term returns but are unreliable over shorter periods, especially in a volatile election year?
These aren’t simple questions.
Two Key Factors
Money market fund investors need to consider two powerful factors — inflation and short-term interest rates. The trend for both is clearly downward.
For months now, inflation has been dropping, and this past week, there was fresh evidence that this positive development continues. The annual rate of inflation fell to 2.9 percent in July — the first time since 2021 that it has fallen below the 3 percent threshold.
Largely because of declining inflation, the Federal Reserve is widely expected to start reducing short-term interest rates at its next meeting in September. The futures markets are divided on whether the Fed will cut the benchmark federal funds rate by one quarter or one half a percentage point then. But the consensus is that a series of rate cuts will be coming, pulling the benchmark federal funds rate to the 4 to 4.25 percent range by January.
I’m not sure when rates will fall or by how much. No one else knows, either. But it seems likely that next year, short-term interest rates will be much lower than they are now.
The relationship between inflation and short-term rates determines whether you get a positive real return. Unquestionably, thousands of people are beating inflation now. The average yield on the biggest money market funds is more than 5.1 percent, according to Crane Data. That’s a bit lower than the federal funds rate, and much higher than the rate of inflation. There are handsome rates available in some federally insured savings accounts, certificates of deposits and other instruments.
The near-term future is another matter. I do expect that you will be able to earn positive real returns for a while to come because the Fed won’t keep lowering interest rates unless inflation cooperates. So I have no intention of abandoning money market funds entirely.
In fact, if you haven’t been using money market funds at all, you may want to start. Check whether you have money in a brokerage “sweep account” or sitting in a bank account. If you aren’t getting anything close to 5.1 percent (or higher) for your cash, you may want to switch to a money market fund and then consider what to do down the road.
That said, the odds are increasingly high that the Fed will act fairly soon to reduce rates, and once it gets started, those attractive money market yields will start dropping precipitously.
Real Returns
The gap between interest rates and the rate of inflation is a moving target. Only since the spring of 2023 have real money market rates been unequivocally positive. That means you’ve actually been earning money, after inflation, with minimal risk. (There is some risk in money market funds because they are not government-guaranteed, but they invest in safe government securities heavily or exclusively, depending on the type of fund.)
In June 2022, it was a very different situation. I pointed out then that soaring inflation would soon create better opportunities for stashing cash because the Fed had already begun responding to the surge in consumer prices by increasing interest rates. That month, the rate of inflation soared to 9.1 percent annually — the highest in more than 40 years. And in what in hindsight was clearly a belated response, the following month the Fed raised rates three-quarters of a percentage point, the biggest jump since 1994.
Until the inflation surge and the rise in short-term rates, money market funds — as well as bank accounts — were paying virtually nothing for your money. That’s because the Fed had been holding short-term interest rates near zero since the Covid-19 recession in the winter of 2020.
In 2022 and 2023, the Fed raised rates to the 5.25 to 5.5 percent range, where they have been stuck for more than a year. Money market fund rates rose, too, but with a lag of up to three months. That lag will be important when the Fed starts to cut rates. Astute (or lucky) fund managers will stock up on higher-yielding, longer duration securities and, for a short while, be able to offer yields that are slightly higher than the federal funds rate. But before long, money fund rates will settle at a spot close to the Fed’s benchmark rate, minus expenses, which is essentially where the best-yielding money market funds are now.
Investment Implications
Don’t obsess about short-term interest rates, though. Over the long haul, money market funds, Treasury bills and other short-term fixed-income instruments are poor investments.
Morningstar Direct, a service of Morningstar, the financial services company, provided me with data from 1926 through 2023. It showed that the return on three-month Treasury bills, a rough equivalent for modern money market rates, was 3.3 percent annually. That compared with 10.3 percent for stocks in the S&P 500 and its predecessors, and 5.1 percent for government bonds over that entire period. Inflation averaged 2.9 percent annually.
Those numbers don’t include the toll of taxes. If you factor in inflation and taxes, you had a negative return for money market funds and Treasury bills, barely broke even with taxable bonds and had an annual real return of 5.2 percent with stocks, by far the best investment among these assets for the long term.
Periods of high inflation, like those of the last few years, are when short-term investments like money market funds really shine. I looked at three of Vanguard’s plain vanilla index funds and found that their Federal Money Market Fund had higher returns than their Total Bond index fund through July for the last one-year, three-year and five-year periods. The Vanguard Total Stock Market index fund had better overall performance but in the tumultuous year of 2022, when inflation and interest rates soared, the money market fund’s steady stream of income provided the best return of the three asset classes.
Money market outperformance isn’t likely to last, though. If you accept that inflation is on the wane, that interest rates are likely to fall and that the markets are returning to something closer to their longer-term profiles, then expect money market funds and other short-term vehicles to underperform. I expect that will be the case sometime in 2025, and maybe even for the rest of this year.
So it’s time for a change. For the money I need in the next year or two, money market funds will be appropriate. For nearly everything else, long-term asset allocation using low-cost index funds is likely to pay off. I’ll plan on a mix of stocks and bonds, emphasizing bonds and certificates of deposit for the money I’ll need over the next five or 10 years.
If you’ve been benefiting from high short-term interest rates, congratulations. But it’s time to make sure you have put together a careful, long-term investing plan.