In short:
- Money market funds have achieved stable returns of over 5% annually
- Inflation and short-term interest rates are trending downward
- The Federal Reserve is likely to begin cutting interest rates soon
- Investors rush to money market funds ahead of possible interest rate cuts
- Long-term investments in stocks and bonds generally outperform the returns of money market funds
The world of money market funds is undergoing significant changes as investors and financial experts anticipate impending interest rate cuts by the U.S. Federal Reserve.
For over a year, these funds have provided investors with a safe haven with annual returns of over 5%, outperforming inflation and providing a stable alternative to volatile stock and bond markets.
However, the period of high returns may be coming to an end, requiring a reassessment of investment strategies.
Current data shows that inflation is declining, falling to 2.9% in July 2024 – the first time it has fallen below 3% since 2021.
This decline in inflation, along with other economic factors, has led to expectations that the Federal Reserve will begin cutting short-term interest rates at its upcoming meeting in September.
Market forward rates indicate that the key interest rate for federal funds could fall to 4 to 4.25 percent by January 2025.
In light of these changes, investors are taking action. Bank of America reported that $37 billion flowed into money market funds in the week leading up to August 23, 2024.
This inflow puts these funds on track for their largest cumulative three-week inflow since January, totaling $145 billion.
Rushing into money market funds ahead of expected interest rate cuts is a common strategy among investors because these funds typically offer higher returns over a longer period of time compared to short-term Treasury bills.
Despite the current attractiveness of money market funds, financial experts point out that they may not be the best long-term investment strategy.
Historical data from Morningstar Direct shows that the average annual yield on three-month Treasury notes (roughly equivalent to modern money market rates) was 3.3% from 1926 to 2023.
By comparison, stocks in the S&P 500 and its predecessors returned 10.3 percent annually, while government bonds returned 5.1 percent over the same period.
Taking inflation and taxes into account, money market funds and Treasury bonds often achieved negative real returns over long periods of time.
Equities, on the other hand, offered the best long-term performance of these asset classes, achieving an annual real return of 5.2% after taking inflation and taxes into account.
The current environment of high returns for money market funds is atypical and likely temporary. As inflation eases and interest rates potentially fall, these funds are likely to underperform relative to their recent peak returns.
Financial advisors point out that while money market funds remain suitable for short-term cash needs (one to two years), investors should consider reallocating their portfolios for the long term.
A mix of bonds and certificates of deposit might be more suitable for the cash needs of the next five to ten years.
For longer-term investing, a diversified portfolio of low-cost index funds is often recommended, with an emphasis on a balance between stocks and bonds for potentially better returns.
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