Vanguard published an article entitled, "Tried and true money markets get boost with rising rates," which summarizes, "Nafis Smith, principal and head of Vanguard's taxable money markets, discusses money markets in a rising interest rate environment, the stress tests behind Vanguard's stability mandate, and how a low fee structure advantages money market portfolios." Smith comments, "Money market rates surpassed the 4.5% mark in February 2023; they were close to 0% at the start of 2022. This higher rate makes money markets very attractive right now, but it also makes the hurdle rate -- the minimum acceptable rate of return -- for investing in other asset classes very high. This probably won't change until we get a little more clarity about when the U.S. Federal Reserve will stop hiking rates and where inflation will shake out."
He explains, "For investors, it's like they're getting paid to be patient while the Fed works toward its goals around inflation. Inflation has been at a 40-year high and, while you don't typically think of money markets as a hedge against inflation, at current yield levels, they take a big step toward neutralizing the erosion in purchasing power today's inflation is creating -- and that's in a portfolio without any price volatility."
Smith tells us, "Money market funds are typically used as a short-term savings instrument, an emergency reserve, or a general allocation to cash. Historically, when the Fed is raising rates, bank deposit rates will adjust much more slowly than will a money market fund's rate. From that perspective, you might be better off with a money market portfolio, but with regard to asset allocation, that really depends on an investor's goals and objectives."
He continues, "That said, money market funds are designed to seek both stability and provide current income. We've gone through two periods since 2008 when rates have been close to zero; if you're an investor who likes the income-generating feature of money market funds, well, you haven't seen a lot of that during these recent low-rate periods. But with money market yields where they are now -- 4.5%-plus and possibly higher in the coming months -- it's an attractive time to be a money market investor."
Smith also says, "Money market funds are highly correlated with short-term interest rates. If you look backward at how much the federal funds target rate has changed over the past year, you'll see that money market rates have moved right along with them. So, as we move into a different interest rate regime, we expect money market fund yields will reflect that movement."
He adds, "At the same time, investors may want to consider whether they're being fairly compensated for their cash reserves. Traditional checking and savings accounts are great for paying bills or building an emergency savings account, but rising rates mean money markets may bring better returns. Right now could be an exciting time to be invested in the money markets."
The Vanguard piece quotes Smith, "The primary mandate of any money market fund is to seek both stability and provide current income. In a rising interest rate environment, any of these four types of money market funds -- U.S. Treasury, government, municipal, and prime funds -- should meet that decree. They all hold high-quality assets, are very liquid, and are subject to the same SEC regulation, Rule 2a-7, which is very prescriptive in terms of how much duration risk a fund can take on and how much liquidity must be maintained.... Treasury and government funds are on the safer end of the spectrum; at the same time, investors may want to understand the risks associated with a prime fund, which can invest in a broader spectrum of money market eligible securities."
He states, "Since their introduction in 1971, money market funds have broken the buck just two times. The first was in 1994, when a fund was liquidated at 96 cents per share because of large losses in derivatives. The second was during the financial crisis of 2008, because of assets held with the then recently bankrupt Lehman Brothers. In response to the 2008 event, the Securities and Exchange Commission amended Rule 2a-7, which increased the resilience of money market portfolios and made them much safer than they used to be. Since then, we've seen several additional rounds of reform. In short, breaking the buck was a rare event before, but since the regulations have changed, it's even less likely to occur."
Smith also states, "Fed repurchase agreements are very common in the money market space. It's an overnight lending arrangement between us, in this instance, and the Federal Reserve, which is one of the world's highest-quality organizations in terms of credit risk. We're lending cash and receiving U.S. Treasuries, which are extremely high-quality securities held on the Federal Reserve's balance sheet. The Fed buys back the U.S. Treasuries the next day at a higher price based on Fed target rates, which provides income to money markets."
He adds, "In a rising interest rate environment like the one we're experiencing, any repurchase agreements are very good at dampening market volatility because they allow us to increase stability by reducing interest rate risk. Repurchase agreements also allow us to pass along the higher interest rate to investors much more quickly."
Finally, when asked what makes Vanguard unique, Smith responds, "Our greatest advantage is our low expense ratio, which allows us to do things differently than some of our competitors. We don't have to take on unnecessary risk to reach for yield, and we can manage our portfolios with much shorter durations, maintain higher credit standards, and enforce stricter underwriting standards for our repurchase agreements while still offering a competitive return."
