Cash has been a haven for investors during the era of higher interest rates, but that opportunity may be changing. David Roberts, Head of Fixed Income at Nedgroup Investments, explores what happens when money starts to leave cash and where it is likely to flow next.
Money market fund assets in the US alone are estimated to be running at close to $8 trillion, a figure that has grown steadily as savers and institutions have taken advantage of the highest cash rates seen in a generation.
It is easy to understand the appeal. After more than a decade in which cash paid next to nothing, being able to earn a healthy, low-risk yield simply by holding money market instruments has felt like a genuinely attractive option, requiring no real thought about duration, credit risk or market timing.
The question worth asking is what happens to that enormous pool of capital once the current rate environment starts to change? And what history can tell us about the pattern that typically follows?
The mechanics of a cash rotation
Money market funds are, by design, extremely responsive to short-term interest rates. When central banks cut rates, money market yields fall in step, usually within one or two rate decisions.
Bond yields, on the other hand, tend to move in anticipation of rate cuts rather than in response to them, because markets are constantly pricing in the future path of policy rather than simply reacting to what has already happened.
This creates an important, and often under-appreciated, sequencing issue for cash-heavy investors. The most attractive point to reallocate out of money market funds and into longer-duration fixed income is typically before the first rate cut arrives, while bond yields are still elevated and cash is still paying an attractive rate.
Once the first or second cut has actually landed, money market yields begin to fall visibly, and it becomes apparent, in hindsight, that the opportunity to lock in higher yields further out the curve has already started to close.
In practice, most investors do the opposite. They wait for clear, unambiguous evidence that a slowdown is under way and that a series of rate cuts is coming, by which point a meaningful part of the potential capital gain in bond markets has often already occurred.
This is a natural, understandable behaviour. Nobody wants to reallocate out of a comfortable, high-yielding cash position on a hunch.
But it means that the eventual rotation out of money market funds tends to happen later, and capture less value, than the mechanics of the cycle would ideally allow.
Where does the money go next?
History also suggests that money leaving cash does not move in one direction only. Some of it flows into bond funds, as investors seek to lock in yields before they fall further. But a portion typically flows into equities as well, particularly if falling rates are interpreted as supportive for growth and corporate earnings, rather than as a signal of economic weakness.
Which of these two destinations dominates tends to depend heavily on the reason behind the rate cuts in the first place.
If central banks are cutting because inflation has been brought under control without significant economic damage, a rotation into risk assets, including equities, becomes more likely.
If, on the other hand, cuts are a response to a more pronounced slowdown, investors have historically been more inclined to favour the relative safety of bonds, at least in the earlier stages of that cycle.
There is also a valuation dimension worth considering alongside the mechanics. Equity markets in aggregate are trading on demanding multiples relative to their own history, with strength concentrated in a narrow group of companies.
Government and corporate bonds, by contrast, currently offer a level of income that has not been consistently available for well over a decade.
That combination does not guarantee which asset class performs better once cash starts to move, but it is a relevant consideration for anyone deciding where a rotation out of money market funds should ultimately land.
A cycle worth planning for, not reacting to
The scale of money currently sitting in money market funds is not, in itself, unusual by historical standards; there is almost always a large pool of cash sitting on the sidelines.
What matters more is recognising the mechanics of how and when that cash typically moves, rather than waiting for the shift to become obvious.
The practical lesson is one of timing discipline rather than prediction. Trying to call the exact moment central banks begin cutting rates is difficult, and arguably unnecessary.
What is more useful is understanding that the reward for anticipating that shift, even partially, tends to be considerably greater than the reward for waiting until it has clearly arrived.
Cash has served investors well over the past two years. The evidence from previous cycles suggests that patience, rather than complacency, will determine how much of that value can be preserved and extended into the next stage of the interest rate cycle.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
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