Cash Is Back, but Beware of the Risks

Last Edited by: LPL Research

Last Updated: April 13, 2023

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Summary:

After years of yielding close to zero, cash is an attractive asset class again. And investors have taken notice, with over $5 trillion sitting in money market funds—the highest amount ever. And while we think holding some cash can be part of a smart investment strategy, most investors, at this point, probably have more cash than they should. And believe it or not, there are risks to sitting in cash. In this edition of the LPL Street View, Fixed Income Strategist Lawrence Gillum explains why cash is a viable asset class again, but investors need to be aware of the risks.

Economists like to remind us there is no such thing as a free lunch. In investment parlance, that just means all investments carry risk—even cash. After last year’s aggressive rate hiking campaign from the Federal Reserve (Fed), short-term interest rates are at levels last seen in 2007. Moreover, due to the elevated fed funds rate and the subsequent carryover into the U.S. Treasury market, the Treasury yield curve is the most inverted since the early 1980s (that is shorter-term Treasury securities out yield longer maturity securities). As seen on this chart, yields on Treasury securities that mature in one year or less are approaching 5%, which is up significantly since the end of 2021. This has (finally) allowed investors to generate a return on cash—and investors have taken notice. According to ICI, a company that tracks investment flows, more than $5 trillion is sitting in money market assets, which is double the amount pre-COVID-19. So where is the risk that economists warn us about? The big risk with cash is reinvestment risk. That is, while short-term rates are currently elevated, the risk is that these rates won’t last, and upon maturity, investors will have to reinvest proceeds at lower rates.

The Fed continues to fight elevated inflationary pressures by raising short-term interest rates. Over the past 12 months, the Fed has taken its fed funds rate to 5.00%, and they may not be done yet either. We think the Fed could raise rates another 0.25%, which would take the rate to 5.25%—the highest level since 2007. The Fed’s goal has been to take the fed funds rate into restrictive territory to make the cost of capital prohibitively expensive to slow aggregate demand, which will allow inflationary pressures to abate. Then what? Well, after winning its fight with inflation, which we think it will, markets expect the Fed to start cutting rates as early as this year. After keeping rates at these elevated levels, the Fed will then likely take the fed fund rate back to a more neutral level, which economists believe is 2.5% or even lower. Just as the aggressive rate hiking cycle took Treasury yields higher, interest rate cuts will take Treasury (and other bond market) yields lower—that is when the reinvestment risks of investing in cash will show up.

Here is a simple exercise that looks at the outcomes of an investor who allocates $1,000,000 in cash and then rolls over the investment proceeds at maturity back into cash at the prevailing market interest rate, versus investing in a core bond strategy that is yielding 4.6% (which is the current yield on the Bloomberg Aggregate Bond Index). Over shorter horizons, certainly cash is an attractive option, but for investors with a three to five year time horizon, the difference in sticking with cash versus owning intermediate maturity fixed income instruments is pretty meaningful.

While we certainly think cash is a legitimate asset class again, it’s all about balancing today’s opportunity with what may or may not be available tomorrow. So, unless investors have short-term income needs, they may be better served by reducing some of their excess cash holdings and by extending the maturity profile of their fixed income portfolio to lock in these higher yields for longer. Bond funds and ETFs that track the Bloomberg Aggregate Index, along with separately managed accounts and laddered portfolios, all represent attractive options that will allow investors to take advantage of these higher rates before they disappear.

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This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth in the podcast may not develop as predicted and are subject to change.

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