Why Money Market Rates Could Stay Low a Long Time

Mike Kauffelt, CFA, Chief Investment Officer

I recently read a thought provoking piece of research that addressed the issue of where short-term money markets rates would be in the future. To give full credit to the author, his name is Paul McCulley and he writes research for PIMCO (one of the best bond fund management shops around) and he specifically focuses on the Federal Reserve. His research piece is entitled Fed Focus and the issue I am referring to is the August 2003 edition. The report was quite detailed and involved many insights on the Federal Reserve and its inner workings. However, it was a conclusion he came to at the end of the report that was really interesting to me, particularly in the light of the many comments (typically frustrated ones) we frequently get about the rock bottom rates paid by money market funds on cash balances.

The bottom line is that if the Fed is able to control inflation, which it appears it has, then we should expect a very steep yield curve in the future. Let me give an example; if inflation is predicted to stay around 2%, then money markets should pay 2% and longer dated maturities would be at higher rates (3 year bonds might be at 4%) based on the length of time and the risk involved. Therefore, we should expect short-term rates to approximate inflation, medium term rates to be slightly higher, and longer term rates to be higher still. This is an example of a steep yield curve. When you graph the above information, the data points, when connected by a line, would curve upward from the southwest to the northeast creating a steep curve. This paragraph has now gotten more complex than necessary; McCulley’s ultimate conclusion is you should not expect to get rewarded for holding cash. If you want higher returns, you must take risk.

Many investors would love to hold all their money in money market type accounts, yet they still expect 10% returns. For a brief period in the early eighties, you could earn 10% in money market funds. But investors should not expect those types of returns going forward. You do not get “paid” when you hold money in your pocket and in a capitalist society you should not expect to earn any REAL return (the return above the rate of inflation) for holding “cash like” investments. The Fed sets policy and ultimately controls short-term interest rates, and it is expected to keep rates low into the foreseeable future. This means investors who want to earn real rates of return above inflation will have to take risk in stocks, bonds, funds, etc. This is obvious to some investors, but not to others. Many people assume that since rates came down from high levels that they will soon go back up. This may eventually occur, but if this Fed and its policy have their way, rates won’t go up anytime soon (think years). Money on the sidelines in cash equivalent investments should expect to lose purchasing power and miss out on growth opportunities over the long-term to money invested wisely in risk bearing assets. Bill Few Associates helps investors manage that risk.