Cash .. A Changing Landscape?
Interest rates are falling. High yield cash has been a great place to be for a long time now. Is this still the case and what are some possible alternatives in this changing environment?
On Wednesday, September 18th 2024, the Federal Reserve cut the interest rate on Fed Funds (which is essentially the rate at which banks lend to each other) for the first time since 2020. Unlike mortgage rates, which pivot mostly off the market-priced 10 year Treasury rate over which the Fed has no direct control, high yield savings account rates (see my post: Cash Is Interesting Again. And Safer Than Ever for more details) are tied extremely closely to the Fed Funds rate.
As a consequence, high yield savings interest rates were all quickly lowered across the board, in many cases by 0.50% which was the size of the Fed Funds cut. The general expectation is that - absent a dramatic spike in inflation - the Fed will continue this rate-cutting cycle, with more reductions in the pipeline for later this year and into 2025, which will provide further downward pressure on the interest that you will be earning on cash held in high yield savings accounts.
The question therefore becomes; is there a point at which high yield savings is no longer the most optimal place to hold short term or emergency money? The answer is (sorry, I know this is always an unsatisfactory response!) .. it depends.
Let’s first look at Emergency Funds/Rainy Day Funds. These are accounts that hold an amount of money determined as a multiple of your expenses to cover possible unforeseen spending at an unknown point in time in the future triggered by a catastrophic event such as a sudden, unexpected loss of income, a major unanticipated expense or a significant medical outlay. As such these are critical risk management tools that everyone should have.
Absent the existence of any Emergency/Rainy Day Funds, these costs will need to be promptly and without warning covered by a) premature liquidation of investments, or b) borrowing - neither of which are palatable options and could prove very stressful and costly as well as potentially highly damaging to the achievement of your longer term investment goals such as retirement or college funding.
The important thing to bear in mind is that there is no predictable timeline attached to these accounts. An emergency or an abrupt expense could happen tomorrow or may never happen at all. For this reason, the guarantee of a return OF principal when required is far more important than the return ON principal. Chasing gains or injecting any level of risk into these accounts is extremely unadvisable since you need to be 100% confident that these funds will be there if needed.
For this reason, my recommendation is that, regardless of what the Fed does to interest rates, Emergency/Rainy Day Funds should still be kept in a high yield savings account, preferably one such as those offered by Betterment or Flourish for example that have literally millions of dollars of enhanced FDIC insurance, completely eliminating any credit risk.
The picture is a bit more nuanced when it comes to saving for a specific short term goal. Generally speaking, money that you are likely to spend within the next two to three years should not be exposed to any stock market risk at all. Think 2001/2002, 2007/2008 or, more recently, 2022. While every one of these crashes have been eventually recovered from with subsequent new all-time highs in stock indexes, it often took a while to happen. If your need for that money cannot wait out this recovery time, you risk realizing significant losses and/or generating taxes when withdrawing that money from stock market investments.
That is why the recommendation has recently been to keep such funds in high yield savings accounts with plenty of FDIC insurance and offering around 5% in no-risk interest such as at the platforms mentioned above. As that interest rate falls though, it can proportionately increase the attraction of a low risk bond-based portfolio as an alternative to at least some of the these assets.
In a scenario where high yield interest rates fall significantly (and I would suggest that we are not quite at that level right now in September 2024 with rates still in the mid-4% range) and you are perhaps closer to the longer end of that two to three year time horizon, it may be worth considering taking a small degree of risk for a portion of the money in a carefully thought-out, customized bond portfolio that emphasizes income over principal growth.
By risk, I mean that the principal is now subject to a degree of value fluctuation due to the price changes of the bonds in the portfolio. Bond prices increase as interest rates fall, but the reverse is also true, so much of the risk lies in a sudden change in trajectory to an increasing interest rate environment. This is considered unlikely at least in the short term, barring the kind of inflation shock referred to earlier.
Compared, however, to the short term volatility in a stock-heavy portfolio, these fluctuations are likely be very muted anyhow, but it is important to understand that they do introduce an element of risk that is simply not present in a high yield savings account.
The potential payoff for starting to take this small amount of risk is that the interest received on the portfolio has the capability to exceed that of the falling interest savings account and, because the maintenance of the principal is perhaps a little less crucial than in an Emergency/Rainy Day Fund, it may be worth taking for some of the shorter time horizon assets, maybe as a hybrid with maintaining some high yield savings.
Obviously, taking this slight extra degree of risk becomes relatively more appealing the lower high yield savings rate falls and the further out on the time horizon spectrum you are. Money expected to be spent in, say, six months time should still be 100% kept in high yield savings however low that interest rate goes, but consideration of this bond fund strategy could be suitable for some two to three year money.
I am happy to work with clients of Anglia Advisors to select an appropriate low risk, income-driven bond portfolio for some of their short term money if they want to use this game plan at some point as high yield rates continue to fall. Please arrange a call to discuss. A few examples of some of the exchange traded funds that DIY readers may want to consider as ingredients for putting together such an portfolio are IEI, TFLO, IGEB, HYDB and NEAR.
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