How Investors Can Outpace the Returns of Money Market Funds

Key Takeaways

• Schneider points out three practical affects of the Federal Reserve: broadly evaluating the economic conditions and the economic outlook, evaluating monetary policy, and unofficially, dealing with financial stability. That has to do with how banks really function in the world, thinking about how money and money supply works throughout the global economy as we know today.
• Earlier in the year there was a view that there’d be a good number of rate cuts down from that 5% benchmark rate. Today, the combination of higher than expected growth and inflationary expectations are going to be a situation where we actually end up pushing that expectations and rate cuts further into the future.
• $6 trillion in assets have flown into money markets over the past years. There’s a great amount of opportunity for investors to be defensive and in fact safe by earning 5% plus or minus in money market and T-bill-like investments. However, if investors have the horizon and comfort to put money to work over the course of the next six months of the year, effectively they can capture liquidity premiums, which allow them to earn and outpace the returns in a total return format versus being in a money market fund.

Eric Jacobson: Hi, I’m Eric Jacobson from Morningstar. The Federal Reserve began raising short-term interest rates in early 2022 and stopped a little above 5% during the second half of 2023. By the end of the year, investors believed that the Fed would soon start cutting those rates several times during 2024. It all went out the window earlier this year, though, when it looked like inflation might not be in check after all, and the picture for lower short-term rates has since become a lot cloudier. Joining me to discuss how we got here and where we might be going is Pimco’s Jerome Schneider. He and his team are responsible for managing the short-term investments under Pimco’s charge, which has put him in the center of the story for several years.

Jerome, thank you so much for being with us today.

Jerome Schneider: It’s great to be here, Eric. Thank you very much to you and Morningstar for having us.

How the Federal Reserve Directly Affects Investors

Jacobson: So, many people know that the Federal Reserve focuses on inflation and employment. For some, though, how the Fed’s actions directly affect them as investors or consumers might be less obvious. Can you give us a thumbnail explanation for how the Fed can directly affect their investments and their daily lives?

Schneider: Yeah, absolutely. Without a doubt, the Fed, to some, might just simply be an arcane white building sitting in the middle of Washington, D.C., but there’s actually practical implications. There’s three of them primarily to note. Number one, the Federal Reserve and its economists will more broadly try to evaluate the economic conditions and the economic outlook. And in doing so, they’ll give us economic outlook forecasts every quarter or so that portends to explain where the US economy has been but also perhaps where it’s going as well. Those are important to help create and foster different sentiments from investors, as well as the general investing population, as well as companies in terms of how they think about spending and employment. But more importantly, we’re also thinking about the Federal Reserve’s view in terms of interpreting data, which comes into the second part of their conditions. Which is evaluating monetary policy.

And monetary policy has evolved over the last several years, as our audience has known, not only to be how much money is in the money supply, but also what are the monetary rates, meaning the benchmark rates, which the Federal Reserve is going to dictate to, as well as influencing other factors within financial conditions influenced by use of their balance sheet, which is a relatively new part of monetary policy over the past few decades but, more importantly, also has an impact on monetary conditions. And what this all means is that the Fed’s mandate, which is focusing on job creation, as well as managing inflationary expectations, comes under that purview of monetary policy. So that second element of what the Federal Reserve does is very important.

And the third leg, which is not necessarily so official, has to do with thinking about financial stability. That has to do with how banks really function in the world, thinking about how money and money supply works throughout the global economy as we know today. These are all factors where the Federal Reserve may or may not necessarily come into play during times of financial stress and uncertainty. Perhaps those that we’ve witnessed during 2008, as well as more recently, during the pandemic. But these are situations where the Fed can independently and more importantly have a direct effect on consumers and investors in terms of how they live their daily life. And more importantly, how they plan for the future through their investments.

Will the Fed Lower Interest Rates in 2024?

Jacobson: Given the latest inflation news you mentioned, what are the prospects for lower interest rates in 2024 still?

Schneider: The prospects are narrowing quite honestly, Eric. And in that regard, what we’ve witnessed over the past two years is a drastic readjustment not only to a more of a normalized interest rate from the zero rates that we had to come to for almost a decade, to more rational rates, which reflect a higher growth opportunity coming from the postpandemic cycle, as well as higher inflationary pressures. We find ourselves today about 5% in terms of those benchmark rates, which represents not only a higher nominal yield, but also a higher real yield, which means there is a real inflation earned return after inflation, given those yields. And so from that perspective, we find ourselves in a relatively tight and a tightening environment where the money supply and, more importantly, the rates are being used to help try to slow inflation and perhaps slow the economy in the medium term. That’s a pretty drastic change. And even as we get here into the later parts of 2024, the accommodation effectively from the monetary central bank is going to be subsiding somewhat.

And I think that we’ve seen earlier in the year there was a view that there’d be a good number of rate cuts down from that 5% benchmark rate. But now where we sit here today, the combination of higher than expected growth and inflationary expectations, not only in the near term but longer term, persisting due to a variety of factors, including wage pressures and good pressures reemerging. Those are going to be a situation where we actually end up pushing that expectations and rate cuts further into the future. And so the remainder of 2024 could perhaps be a sit and wait as we get further information from the Federal Reserve and, more importantly, as we all collectively continue to digest some of this valuable information in terms of growth information as well as inflationary information, which means that we’re probably looking to 2025 as an area in a time frame where we can see a more deliberate response. And given the uncertainty, it perhaps is to more tightening, meaning higher rates in the future if inflation remains stickier than we expect. Or it perhaps means that we’re just simply here on hold for a longer period of time than the markets and even some professionals expect at this point in time.

How Low Is the Fed Willing to Go?

Jacobson: So it sounds like you think there’s even a possibility at some point that they may have to go up. But for now, let me ask you, let’s say for the sake of argument that we get into next year and the Fed does decide to start cutting, how low do you think they might naturally go or how low do you think the Fed might be willing to go at some point if things look better?

Schneider: Absolutely. I think that’s exactly where we’re sort of thinking about the longer-term implications here. And while it’s really important to understand and digest the day-to-day data which comes into the marketplace, for investors, what they want to do is try to rationalize the longer-term risk and reward that comes into it. And admittedly, we here at Pimco are thinking about the world of perhaps a secure inflation outlook. It has a nonzero probability of a further rate hike in the more immediate future. But you’re right, in the longer term, we have to rationalize how we want to think about the prospect of rate cuts into that future. And it probably will likely happen for a variety of reasons. Number one, the tightening monetary policy will inevitably be successful at some point in time to slow down growth and slow down inflation. It depends upon what kind of landing, hard landings or soft landings, that nomenclature lends itself to two decidedly different outcomes. But in the end perhaps leads itself to easier monetary policy in the longer term. And we foresee that definitively over the secular horizon the next three to five years. But more importantly, I think when you look at where the Federal Reserve views its neutral rate to be, and again not to sound too wonky to our investor base and the watchers, but the neutral rate known as R-star is perhaps the destination for where we think that ultimately these rates will end up getting to, which is hundreds of basis points lower than we are now. So for context, sitting here at benchmark rates above 5%, it’s probably in the realm of 3% or just above or below that 3% realm. So there’s a couple hundred basis points or percentage points of easing, lowering of rates, that might potentially come over that point in time in order to accommodate the economy, should it meet a rough patch or otherwise.

But that doesn’t mean it’s in the immediate future, Eric. And I think that’s the construct here of trying to create balanced portfolios given the outlooks, not be too minded that the Fed will cut more immediately, once as the market really prospected earlier in 2024. And yet at the same time, rationalize the higher growth and actually the good outcomes and the good optics that we are seeing also in the economy in the near term. Those don’t necessarily coincide with necessarily a course of action to take advantage of longer end rates right now, specifically because of longer-term inflationary premiums, as well as the notion of where we’re heading for issuance and supply from the US Treasury. But it does mean that where we sit here today, more importantly, here at 5% to 6% returns closer in the front end of the Treasury curve, as well as being focused on that zero to 10-year space, again, the front end of the Treasury curve, plus some additional diversified spread, it creates some interesting opportunities for investors to sort of look at fixed income in a whole different light than where they’ve been for the past decade-plus. So while the destination might inevitably be lower rates, which by the way, also means that there’s capital appreciation for your bonds along the way as prices move higher with lower yields, it also means that we could be here for the—where we stand right here is a pretty attractive locale to begin to put your feet in the water of fixed income at this point in time. So it’s a pretty exciting time just given the confluence of events.

How Do Money Markets Compare With Other Short-Term Opportunities?

Jacobson: Jerome, taking that into account, how attractive, for example, are money markets these days relative to other short-term opportunities?

Schneider: Yeah, without a doubt, it’s a great question. In fact, it’s a $6 trillion question at this point in time, given the amount of assets that have flown into money markets over the past years. Listen, there’s a great amount of opportunity for investors to be defensive and in fact safe by earning 5% plus or minus in money market and T-bill-like investments. We fully understand that, as investors, and understanding why people want to have that beautiful triumvirate of capital preservation, liquidity management, with some positive return for once. But what we also are finding is that there’s a revealing aspect of fixed income right now that if you move just slightly beyond the money market space into that zero to one-year space in a more diversified portfolio, away from Treasury bills, away from money market strategies, that you can have additional opportunities through earning additional income as well as being senior in different opportunities for corporate bonds as well as asset-backed securities, which are quite attractive. And it puts a total return metric well above 6% at this point in time without taking much interest-rate exposure at this point in time.

Said a little bit differently, if investors have the horizon and comfort to put money to work over the course of the next six months of the year, effectively they can capture liquidity premiums, which allow them to earn and outpace the returns in a total return format versus being in a money market fund. And that’s really the attractive spot that we haven’t seen in quite a few years, perhaps dating back to 2015 when short-term strategies became once again in focus in a higher rate cycle. This, too, now lends itself to be very relevant for investors who want to be in that 6% to 8% returns without having a lot of aspects of taking a lot of risk, managing interest-rate exposure at the front of the curve, but yet having the time horizon to put money to work over the next few months or the next few quarters, there’s attractive ways to do that. And so we would encourage, effectively, investors to tier their cash, think about what they need for same-day liquidity, keep that in money market funds, AAA rated, government guaranteed type of obligations, but to the extent they can tier their cash over the next few quarters, it makes it a very attractive opportunity whether you’re an individual investor, a corporate cash CFO, or even a pension or foundation, if the opportunities are there to create those diversified portfolios away from the traditional mindset of cash management.

Jacobson: Well Jerome, thank you very much. It was great to have you with us today.

Schneider: Thanks very much. Appreciate it.

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