Category: Investments

Author: Tim Courtney

Understanding the Impact of the Federal Funds Rate

Date: 11/12/19

For much of the last decade, the federal funds rate — the rate at which banks lend to other banks – has hovered near zero. 1 In late 2015, the Federal Reserve (Fed) slowly started to increase the rate until late 2019, at which point it began to reverse course once again.2 The federal funds rate currently sits in the 1.5 to 1.8 percent range.3


Because the rate reflects the “cost of money” for banks, it ultimately influences the rates banks offer on investments such as certificates of deposit (CDs) and money market funds.


When rates were near zero, it wasn’t uncommon for investors to realize negative returns, especially after taxes and inflation. In fact, looking back at the last decade, investors only briefly saw positive returns on CDs and money market funds from 2016-2018, the brief period when the Fed began to once again raise rates.2


As investors, it’s important that we understand the federal funds rate and how it can impact our earnings. Below are a few things to keep in mind:


1. Watch out for stagnant money. During the six-year period when the federal funds rate lingered near zero, several financial firms waived their fees on money market funds in order to avoid negative yields. When interest rates began to climb again, however, these same firms started adding back their fees, even though several money market investments were still yielding zero.


Investors should look for money that has become “stagnant.” Money market investors have become used to seeing near-zero returns but, in the current market, we believe there is at least some yield to be had. A cash investor should at least be getting somewhere near 1.0 percent to 1.5 percent on cash deposits or money market accounts.


2. Don’t get stuck in a default position. Historically, money market returns have followed inflation. Currently, inflation is holding at 1.7 percent4 and money markets have returned 1.9 percent year-to-date, meaning that after taking inflation into account, purchasing power is roughly flat.5


For many, holding cash is a default position – one in which no principal can be lost. However, over the last decade and for much of the 1940s and 1950s, yields on cash failed to keep pace with inflation (rates were kept low to allow us to pay back debts accumulated during WWII). 2 However, there can be a loss of purchasing power that, if compounded over time, can become very meaningful.


3. It’s happening across the globe. Compared to the rest of the developed world, the United States is in an enviable position. Europe, for instance, began seeing negative rates in 2014 with little to no growth since then. Similarly, Japan introduced negative rates in 2016.6 It is important to realize that market rates, both in the U.S. and globally, have been low, and as such, rates are falling back toward zero on cash and cash deposits across the globe.


During the 60s to the early 2000s, money market investments were the default position for investors because they offered a safe storage of cash that would typically cover inflation and taxes. We believe this will likely not be the case for at least the near future. As a result, the best thing we can do with our money market and cash positions is to make sure we are at least receiving a market rate return. If you have any questions about your cash investments, please schedule some time to review your portfolio with your advisor.


Sources:
1. Investopedia – Federal funds rate
2. Macro Trends – Federal Funds Rate - 62-year historical chart
3. USA Today – The Fed just cut rates again. Here’s what you should do next with your 401(k)
4. Trading Economics – United States inflation rate
5. Vanguard – Federal money market fund
6. TheStreet – Negative interest rates in the U.S.? Here’s what they’ve done to Europe, Japan

     

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About the author

4054781971

tcourtney@exencialwealth.com

Oklahoma City, Ok

Chief Investment Officer

Tim Courtney serves as Chief Investment Officer of Exencial Wealth Advisors and chairs the investment committee. He attained the Certified Investment Management Analyst (CIMA) designation in 2005 a... CLICK HERE TO READ MORE