Money markets start to break 5 percent barrier
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Business & Technology | Personal Finance
By Kathleen Pender
In the next few weeks, money market funds will start breaking the 5 percent barrier, thanks to last week's Fed rate increase.
Will 5 percent lure Americans out of the stock market, or at least out of the mall?
"I think 5 percent holds some psychological significance. In this case it's going to be doubly powerful because rates were so low," says Peter Crane, president of Crane Data.
"Once you break over 5 percent, cash _ which has always been a defensive investment _ becomes an offensive investment as well," says Crane, paraphrasing a comment originated by John Sweeney, a senior vice president at Fidelity Investments.
A small number of banks are already paying more than 5 percent on three-month certificates of deposit and dozens are paying that on six-month CDs, but they don't offer quite the same liquidity as money funds.
Vanguard Prime was the highest yielding money market fund last week, with a seven-day yield of 4.92 percent.
David Glocke, a Vanguard portfolio manager, says fund will break 5 percent "in the next couple weeks."
Money funds closely track the target federal funds rate, which the Fed raised to 5.25 percent from 5 percent last week.
Money funds roughly yield the federal funds rate minus their expense ratios. Vanguard's expense ratio is 0.30 percent or 30 basis points. The average money fund charges about 50 basis points and was yielding 4.5 percent last week, according to iMoneyNet. It usually takes a month or two for an increase in the fed rate to be fully reflected in money fund yields.
"Five percent is the magic number," says Crane. "That giant sucking sound you hear is money moving into cash and CDs. It's just getting started."
Glocke says the main source of cash flow into money funds will be checking and savings accounts, many of which are paying less than 1 percent.
Nobody is suggesting a 5 percent yield will lure hordes of investors out of stocks into cash. Investors are more likely to flee the market following a 300-point drop in the Dow than a quarter-point increase in interest rates.
But a 5 percent yield could keep some money that would have gone into the market sitting safely in cash.
"Where it hits is the fence-sitters, people who are saying should I get back into the market or wait," says Crane. "Right now the pressure is off to put that cash to work. You get paid to wait."
Crane points out that Schwab, E-Trade and Fidelity _ where most people go to buy stocks or mutual funds _ are all advertising CDs on their Web sites.
Tim Huyck, a portfolio manager with Fidelity says, "We have begun advertising our money market funds for the first time in quite some time."
Huyck expects to see deposits increase when Fidelity's money funds hit 5 percent. "When we crossed 4 percent, that generated some interest," he says.
A 5 percent money fund yield could help raise _ to some small extent _ the personal savings rate, which is in negative territory.
That's because 60 to 80 percent of money fund dividends are reinvested in more shares, and the higher the yield, the higher the reinvestment rate, says Crane.
But it's not likely to induce many Americans to spend less. One money fund manager told me that when peoples' jobs are in jeopardy, they save more; when things are good, they spend more.
As long as the Fed keeps raising interest rates, savers should keep their maturities as short as possible. The shortest maturities are usually found in money funds, which had a weighted average maturity of 38 days last week.
The time to lock in longer maturities is when the Fed is done or almost done raising rates.
Before last week's Fed decision, trading in federal funds futures contracts put the odds of another quarter-point rate hike in August at more than 80 percent. After the meeting, the odds dropped to 65 percent, according to Gus Faucher, director of macroeconomics with Moody's Economy.com.
The odds of a rate higher than 5.5 percent were very low.
But many experts I spoke with last week say the Fed is likely to raise rates two or three more times before stopping. "Our outlook for fed funds is 5.75 to 6 percent," says James Bianco, president of Bianco Research.
When Fed Chairman Ben Bernanke says he will be data dependent, he means dependent on one number _ inflation, Bianco says.
The Fed's favorite inflation measure is the Commerce Department's core Personal Consumption Expenditures index. On Friday, the department said this index rose 2.1 percent in May over the previous year. That was in line with expectations, but was higher than the 2 percent limit the Fed is thought to be comfortable with, Bianco says.
If money fund managers thought the Fed was done raising rates, you would see them lengthening the average maturities of their funds.
Glocke and Huyck both expect further rate increases and are keeping their maturities relatively short _ 41 and 40 days, respectively.
"We are not lengthening maturities" says Vanguards' Glocke. "The stock market is rallying as if the Fed is done. I don't think they're right about that."
Money fund maturities generally range from 25 to 80 days.
"When we felt the Fed was on hold or had the possibility of easing (lowering interest rates) we were in 60-70-80-day range," says Huyck.
Of course nobody, not even Bernanke, knows when the Fed will be done raising rates.
That's why it's a good idea to own a variety of maturities and match them to your needs.
If you need money to pay next year's tuition, keep it in a money market fund. If you need it in two years to buy a car, consider a two-year CD. If you are saving for retirement, consider a mix of long-term bonds and stocks. |
