Cash won't flee money-market funds if the Fed gets its soft landing

By Joy Wiltermuth

Returns on longer bonds are negative, again

The Federal Reserve's slow approach to cutting interest rates could keep cash on the sidelines long after the central bank starts to unwind its most aggressive hiking cycle in four decades.

Conventional wisdom says investors shouldn't wait for the Fed to start lowering rates to move out of cash into longer-duration bonds with some of the most attractive yields in roughly 15 years, largely because when cuts start, they can come quickly.

But it's hard to argue against investors wanting to stay put, earning roughly 5% in money-market funds and other cashlike investments, especially when the timing and magnitude of potential rate cuts has been a moving target.

"If you cut too soon," the risk is that progress on inflation will stop, "or even reverse," Fed Chair Jerome Powell said on Wednesday, speaking at Stanford University. Waiting too long, however, could harm the economy, he said, underscoring the central bank's balancing act.

Read: Fed's Powell: Too soon to say if recent higher-than-expected inflation is just a bump

Powell's overall message on Wednesday was that the Fed isn't in a rush to cut rates, with a growing economy and inflation that has significantly eased but remains above the central bank's 2% yearly target.

Fewer cuts, more cash on sidelines

The Fed has been in a holding pattern since last summer, keeping its short-term policy rate steady in a 5.25% to 5.5% range and waiting on economic data to indicate when it's safe to start lowering rates.

Since it began hiking rates two years ago, one of the Fed's biggest tests came with the collapse of Silicon Valley Bank a year ago. Assets in money-market funds swelled by about $1 trillion as deposits fled the banking system for higher yields elsewhere. Inflows into money funds continued, hitting a record $6.5 trillion in February, according to the U.S. Securities and Exchange Commission.

While bank deposits now appear to have stabilized, the outlook for interest rates hasn't. Wall Street's initial estimate of up to seven rate cuts in 2024 has been dialed back to three, two or possibly none.

"What the market has been predicting and what the Fed has been delivering have been very different things," said John Tobin, chief investment officer and manager of Dreyfus, BNY Mellon's money-market mutual funds business.

"It wasn't that long ago," Tobin said, that traders were pricing in a roughly 80% chance of a March rate cut. "That wasn't our base case at all," he said. "We thought June was the right time and still believe that today."

The lack of a clear path to lower rates has kept volatility unusually high in the Treasury market, with climbing 10-year yields BX:TMUBMUSD10Y pressuring returns on bonds. The benchmark Bloomberg U.S. Aggregate AGG was facing a roughly negative 1.6% return on the year through Wednesday, according to FactSet, while the Bloomberg U.S. Treasury (20+ year) TLT was closer to a negative 6.3% return.

Yet for money-market funds, the slow pace to rate cuts has been the gift that keeps giving.

"It's almost a coin toss if June is or isn't in play," Tobin said on Wednesday. "I think this easing cycle remains a tailwind for us."

Fed, not a crisis, is driving policy

Unlike other cycles of the past half-century, the Fed has penciled in three rate cuts for 2024 but isn't facing a major crisis that requires it to significantly slash rates to bolster the economy.

Powell on Wednesday called the Fed "a crisis responder" with tools at the ready, but also said the central bank's overall goal is to do "the right thing" for the economy over time.

The careful stance makes a return to ultralow rates of the past decade look unlikely, while it also boosts the appeal of money-market funds and shorter-duration bond investments.

Jack McIntyre, a portfolio manager in the global fixed-income group at Brandywine Global, said that instead of waiting for cash to bail out of money-market funds, he's thinking in terms of the "year of the coupon."

Bond prices often fall while yields rise in uncertain markets, but coupons are the set interest a bond pays each year. Corporations, households and governments have been paying more to borrow since central banks began jacking up rates to fight inflation.

While McIntyre remains cautious about going too far out on the credit curve, given how acute rate volatility has been in this cycle, he also thinks shorter-duration Treasurys look competitive when compared with money markets, and they give "a bit of optionality" to lock in coupons for an extended period.

"Equities have done well," McIntyre said, pointing to the S&P 500's SPX nearly 10% advance in the first quarter. "But one of these days, you are going to get an economic data point that's going to question the soft-landing scenario."

Should the toll of higher rates trigger a recession or make a hard landing look more likely, deep rate cuts could follow. "You have to have something defensive, just in case," McIntyre said.

Read: Oil, gold and the dollar are surging. Here's why that could derail the Fed's rate-cut outlook.

Stocks were higher on Thursday as bond yields edge lower head of Friday's jobs report for March. Wall Street will be looking for signs of modest softening in the robust labor market. The Dow Jones Industrial Average was 0.3% higher, while the S&P 500 was up 0.6% and the Nasdaq Composite was advancing by 0.8%, according to FactSet.

-Joy Wiltermuth

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04-04-24 1140ET

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