We recognize that many investors have hoarded more cash than necessary as a result of lingering fears from the Great Recession. However, this is becoming increasingly detrimental to your long-term wealth as inflation and interest rates have increased. Despite the recent rise to 2.0-2.25% of the benchmark short-term interest rate in the U.S. (the Federal Funds rate), traditional savings accounts at many banks still pay a measly interest rate of 0.1% or less annually! This is substantially below almost all of the alternatives available to investors. Short-term rates such as the 3-month Treasury track the Fed Funds rate very closely. Using the 3 month Treasury rate of 2.19% as an extremely conservative investment option, your traditional savings account is earning at least $200 less annually for every $10,000 in your account. If you traditionally maintain a $50,000 balance in your savings account, then you’re missing out on at least an additional $1,000 of interest income per year. Therefore, reading this commentary could help you earn an extra $200-$2,000 annually.
The graph shows the average U.S. interest rate on savings deposits of less than $100,000 (blue line) compared to the Fed Funds rate for the past three years. Notice that interest rates on savings accounts do not track the Federal Funds rate. Banks are taking advantage of the historically low interest rates to improve their net interest margins. Investors must be keenly aware of the interest rate they are earning on their cash balances versus what they might earn elsewhere because the difference is meaningful and growing.
Sitting on cash since late 2008 until late 2015 cost investors very little since the Federal Reserve held short term interest rates effectively at 0%. Correspondingly, interest rates across the entire fixed income market remained at historically low levels. However, since late 2015 the Fed has raised short term interest rates 8 times by an incremental 0.25% each time. Therefore, the shortest, safest rate in the U.S., the Fed Funds, is now in the range of 2.0-2.25%. The increase in the Fed Funds has also pushed up short-term and long-term rates throughout the fixed income market. This has made the fixed income market even more attractive given the higher yields available on fixed income investments provided such investments are chosen very carefully to minimize duration (interest rate risk).
The most recent Fed Funds rate increase occurred this past Wednesday. According to its base-case scenario, the Fed is likely to increase rates by an additional 0.25% in 2018 and 0.75% in 2019. The current economic fundamentals support such rate increases. GDP growth has been strong in the 2-3+% range for the past five quarters and is expected by the Fed to be greater than 3% in 2018 and 2.5% in 2019. Also, recent inflation data has picked up and has finally reached the Fed’s 2.0% target the past two months after several years below 2.0%. Correspondingly, wage growth has been gaining momentum, nearing 3% in recent reports, as a very tight labor market pushed the unemployment rate down to 3.9%. The Fed expects to continue to see the unemployment rate decline in 2018 and 2019, which may very well accelerate wage inflation pressures.
The economic fundamentals and expected future short-term rate increases will likely also put upward pressure on long-term rates which is why we often sound like a broken record when we highlight the importance of keeping duration (interest rate risk) low. This year the yield on the 10-year Treasury has risen 0.65% to 3.05% as of Friday. This increase in long-term interest rates is the primary reason many bond indices are actually down a few percent year to date. But it is also why we have worked to minimize duration to avoid exposure to this growing risk.
Investors have a variety of relatively liquid options for investing their cash. A “high” yielding savings or money market account may pay close to 2%, but that return is pre-tax, so it offers little return after taxes. Additionally, inflation is trending around 2%, so the real return is actually zero or negative. A 12-month CD likely offers a bit higher rate, but then your rate is fixed despite the expectation for market rates to rise, and if you need to withdraw early you’ll pay penalties. Once again, after taxes and inflation, your real return is actually negative.
Investors can opt for a longer maturity portfolio that provides a more substantial yield, but that exposes the investor to losses if interest rates increase. A much more compelling portfolio that we build for clients keeps duration low and quality high, while still providing 3.75- 4.00% on a gross basis. As shorter dated bonds mature in a rising interest rate environment, the proceeds can be reinvested in similar quality bonds at a higher yield. Additionally, our bond portfolios typically include a healthy portion of floating-rate bonds whose coupons will actually increase as rates raise resulting in even higher returns. Therefore, in a rising rate environment gross returns on a low-duration, high-quality portfolio could approach or even exceed 4% in the near future.
As an investment advisor, it is our responsibility to help you protect and grow your wealth. After properly funding your emergency cash reserves in a high yield savings or money market account, we recommend excess cash be invested in the fixed income market or perhaps equities. A carefully constructed fixed income portfolio provides returns in excess of traditional savings accounts and money market accounts, while also providing for additional interest rate upside as rates rise.