While the prices of stocks and bonds have often fluctuated painfully in recent years, one area of the markets has remained pleasingly stable: money market funds.
For over a year, investors have been able to earn annual returns of over 5 percent with minimal risk—while significantly beating inflation—simply by parking their money in relatively reliable places.
This wonderful refuge from the storms of the markets is not going away. But with short-term interest rates likely to fall soon, this protection is becoming less comfortable, and it's time to prepare.
It might make sense to look beyond money market funds, lock in the relatively high interest rates now for at least some of your money, and reassess your needs.
Can you afford to invest some of the cash you don't need immediately in bonds, which fluctuate in value but tend to produce better returns over the long term than money market funds? And do you have excess cash that might be better invested in stocks, which are likely to produce better returns over the long term but are unreliable over shorter periods, especially in a volatile election year?
These are not easy questions.
Two key factors
Investors who invest in money market funds must consider two important factors: inflation and short-term interest rates. Both are clearly trending downward.
Inflation has been falling for months, and last week there was new evidence that this positive trend is continuing. The annual inflation rate fell to 2.9 percent in July – the first time since 2021 that it fell below the three percent mark.
Due in large part to falling inflation, the Federal Reserve is widely expected to begin cutting short-term interest rates at its next meeting in September. Futures markets are divided on whether the Fed will cut the benchmark interest rate by a quarter or half a percentage point. But the consensus is that a series of rate cuts are imminent, pushing the benchmark interest rate down to 4 to 4.25 percent by January.
I'm not sure when or by how much interest rates will fall. Nobody else knows, either. But it's likely that short-term interest rates will be significantly lower next year than they are now.
The relationship between inflation and short-term interest rates determines whether you're getting a positive real return. Undoubtedly, thousands of people are currently beating inflation. The average yield on the largest money market funds is more than 5.1 percent, according to Crane Data. That's slightly lower than the prime rate and much higher than the inflation rate. Some government-insured savings accounts, certificates of deposit and other instruments offer attractive interest rates.
The near term is another matter. I expect you can continue to get positive real returns for a while, as the Fed will not cut rates further if inflation doesn't cooperate. So I have no intention of giving up on money market funds altogether.
If you haven't used money market funds at all, you may want to start. Check to see if you have money in a brokerage sweep account or a bank account. If you're not getting anywhere near 5.1 percent (or more) for your money, you may want to switch to a money market fund and then figure out what to do going forward.
However, the chances that the Fed will cut interest rates soon are increasing. And once it starts doing so, the attractive yields on the money market will fall rapidly.
Real returns
The gap between interest rates and the inflation rate is a moving target. Real money market interest rates have only been clearly positive since spring 2023. This means that after inflation has been deducted, you have actually made money, with minimal risk. (Money market funds carry a certain amount of risk because they are not government-guaranteed, but depending on the type of fund, they invest heavily or exclusively in safe government securities.)
In June 2022, the situation was very different. I pointed out at the time that rising inflation would soon create better investment opportunities because the Fed had already begun to respond to the rise in consumer prices by raising interest rates. That month, the inflation rate rose to 9.1 percent annually—the highest in more than 40 years. And the following month, the Fed raised interest rates by three-quarters of a percentage point—the biggest jump since 1994—which, in hindsight, was clearly a delayed reaction.
Until inflation and short-term interest rates rose, money market funds – like bank accounts – paid virtually nothing for your money. That's because the Fed had kept short-term interest rates near zero since the Covid-19 recession in the winter of 2020.
In 2022 and 2023, the Fed raised interest rates to the 5.25% to 5.5% range, where they have been stuck for more than a year. Money market fund rates also rose, but with a lag of up to three months. That lag will be important when the Fed starts cutting rates. Smart (or lucky) fund managers will be able to stock up on higher-yielding, longer-dated securities and offer yields slightly above the federal funds rate for short periods of time. But soon, money market fund rates will settle at a level close to the Fed funds rate, minus expenses, and that's essentially where the best-yielding money market funds are right now.
Impact on investments
But don't worry too much about short-term interest rates. Over the long term, money market funds, Treasury bonds and other short-term fixed-income securities are poor investments.
Morningstar Direct, a service of the financial services provider Morningstar, provided me with data from 1926 to 2023. It showed that the yield on three-month Treasury bonds, which roughly correspond to modern money market rates, was 3.3 percent annually. By comparison, stocks in the S&P 500 and its predecessors returned 10.3 percent and government bonds 5.1 percent over the entire period. Inflation averaged 2.9 percent annually.
These figures do not include tax burdens. If inflation and taxes are taken into account, money market funds and Treasury bonds have a negative return, taxable bonds barely break even, and stocks, which are by far the best long-term investment of this type, have an annual real return of 5.2 percent.
During times of high inflation, like the past few years, short-term investments like money market funds are particularly successful. I looked at three of Vanguard's simple index funds and found that their Federal Money Market Fund had higher returns than their Total Bond Index Fund for the most recent one-year, three-year and five-year periods through July. The Vanguard Total Stock Market Index Fund had better performance overall, but in the turbulent year of 2022, when inflation and interest rates soared, the money market fund's steady income stream delivered the best return of the three asset classes.
However, the outperformance of money markets is unlikely to last. Assuming inflation is abating, interest rates are likely to fall, and markets are returning closer to their long-term profiles, then money market funds and other short-term investments are likely to underperform. I expect this to be the case sometime in 2025, and perhaps even for the rest of this year.
So it's time for a change. For the money I need over the next year or two, money market funds are the way to go. For almost everything else, long-term asset allocation with low-cost index funds should pay off. I plan to have a mix of stocks and bonds, with a preference for bonds and certificates of deposit for the money I need over the next five or ten years.
If you've taken advantage of high short-term interest rates, congratulations. But now it's time to make sure you've put together a careful, long-term investment plan.