Overview
Is it time to get out of money markets? Not necessarily.
Over the past decade, storing capital in safe, low-return cash accounts came with a heavy price: there was almost no return at all. That changed last year, and those decent returns should continue into 2024 - even if official interest rates are brought back down.
Take three core developed market currencies: the pound, the dollar and the euro. The central bank base rate in the eurozone is 4 per cent and above 5 per cent in the UK and US. As Chart 1 shows, in sterling for example, the rise in official rates has taken annual returns on money market investments from 0.06 per cent in 2021 to 4.78 per cent last year.
All three sets of official rates are projected to fall over the next year but running the numbers on a variety of different scenarios of monetary easing shows that the reward for keeping capital in money markets will still be just that: a reward, and not a punishment for holding capital back from riskier bond or stocks plays.
As the chart shows, we ran these calculations for three sets of scenarios: one in line with current market pricing where rates are cut starting in June by 100-125 basis points over the course of 2024; one where the economy performs better than expected and cuts begin later and amount to only 50-75 basis points; and one where the economy underperforms and enters a recession and the Bank of England moves quickly and more aggressively than the current consensus, cutting by 250bps.
Under the three scenarios we show in Chart 2 for official Bank of England interest rates, none of them delivers an annual return of less than 4.4 per cent for money markets.[1]
The idea that rates have now peaked seems locked in with policymakers, but in the absence of the sort of emergencies that took hold in 2008 and 2020, the first reduction may take a quarter or more to materialise and further cuts should only come steadily over the course of the year. So I expect the return on short-term money market instruments to fall only gradually.
The end result for all three scenarios shows the full return for the year is far closer to the initial rate than that at the end of the year. The results for US and eurozone money markets are very similar - with minimum returns of just over 3 per cent on euros and 4.6 per cent in dollars.
Higher for longer
What next? We suspect that, with inflation generally proving stickier, there will be a structurally higher interest rate environment in the years to come than existed before the pandemic. There is also a debate about whether the neutral rate has moved higher now than in the decade before Covid. That means money market investors will in general see far higher returns than they have over the past decade and that cash funds will continue to play an important role in investors’ portfolios.
Of course, hurdles could emerge that change the landscape. Inflation could return as a result of heightened geopolitical tensions, causing further disruption to shipping routes or blockages in core supply chains. Here, central banks may not cut rates so quickly for fear of overstimulating the economy and causing a more prolonged period of elevated inflation.
Alternatively, the economy may finally see more dramatic effects of higher policy rates kick in, and policymakers will find themselves reversing swiftly towards far lower rates than the market currently expects.
Either way, our scenarios suggest that returns for money market investors will remain attractive over the coming year compared to recent history. When market volatility remains high, it makes sense to keep a portion of your portfolio in cash. Not only are the yields compelling on a risk-adjusted basis, but cash has a low correlation to riskier asset classes, so if the worst does occur part of your portfolio will be shielded. And in stark contrast to the past decade, the shield now does more than just protect your money: it grows it.
For another view on options in the changing rate environment, click here
[1] Returns were calculated using compounded daily SONIA, €STR and Fed Funds based on the path of rates in the scenarios.
