Fed’s Message: Take on Risk or Earn No Return
Holding money in a cash account isn’t supposed to be a ticket to great wealth. But in the lifetimes of most Americans, cash has never been as seemingly wretched an option as now.
The Federal Reserve’s surprise decision last week to slash its key short-term interest rate by a half-point, to a 41-year low of 1.25%, will drive interest returns on the trillions of dollars in money market funds, bank CDs, short-term Treasury bills and other so-called cash accounts to new generational lows as well.
Only the Fed knows what signal or signals it wanted to send with the rate cut, the central bank’s first reduction in 11 months. But for savers and investors, one message is loud and clear: Your only chance of earning higher returns is to take more risk with your money -- say, in stocks or bonds.
That’s how markets are supposed to work, of course. Investors shouldn’t expect to be richly rewarded for being chickens.
But older Americans, in particular, can be forgiven for viewing the Fed’s latest move as something akin to a forced-march order. If they stay in cash, they’re guaranteed to earn practically zero on their savings. If they leave for higher-risk securities, they at least have a shot at earning decent returns.
Many times in the late 1990s the Fed was accused of pandering to Wall Street. For example, the three quick rate cuts in the fall of 1998, after the near-failure of the giant hedge fund Long Term Capital Management rocked world markets, were later seen as a direct attempt to shore up stocks -- even though, on Main Street, there was no sense of imminent financial calamity.
For its efforts in the late 1990s, the Fed has since been accused of helping to inflate the stock market bubble by keeping money too easy for too long. The central bank’s supporters say that fails to acknowledge the political realities of the era (i.e., the Fed would have been excoriated if it quashed the economic boom of that period).
Still, last week’s rate cut was roundly viewed as aimed at least in part at bolstering stock prices, which had been rallying for four straight weeks, boosting hopes that the 31-month-old bear market was finally over.
The Fed knew that Wall Street was expecting a quarter-point drop in rates, and Fed officials had said nothing leading up to Wednesday’s meeting to suggest that they would order a bigger reduction.
Thus, the half-point cut was meant to be a pleasant surprise. If the stock market can continue to rebound, after all, it could help pull up consumer confidence, which fell in October to a nine-year low. If consumers are more confident, they may be less fearful about spending. If spending picks up, so should the economy.
One argument that the rate cut was more for the stock market’s psychological benefit than a move meant to directly spur more borrowing is that consumer loan rates already are either at rock bottom or are unlikely to be affected by a new Fed reduction. Car loans at zero-percent are an example of the former; credit card rates are an example of the latter.
Yet so far, the Fed’s move hasn’t been warmly received by equity investors.
Stocks rallied modestly Wednesday, with the Dow Jones industrials gaining 92.74 points for the day. But the blue-chip index slumped 184.77 points on Thursday and 49.11 points on Friday, to end at 8,537.13.
The Dow eked out a net gain of 0.2% for the week, extending its winning streak to five weeks. But the Nasdaq composite slipped 0.1% for the week and the Standard & Poor’s 500 lost 0.7%.
More striking is that the market’s inability to extend Wednesday’s rally was atypical of what usually happens when the Fed gives investors a nice surprise. Investment firm Bridgewater Associates in Wilton, Conn., calculated that, for the magnitude of Wednesday’s surprise, “The current market reaction is as weak as we’ve ever seen.”
Are investors afraid that the Fed’s cut indicates policymakers fear the economy could tip back into recession? The Fed, in its statement Wednesday, said the economy had hit a “soft spot” -- implying a temporary problem.
But the action in the Treasury bond market last week, as in the stock market, wasn’t a rousing vote of confidence in the recovery. Long-term Treasury bond yields fell sharply, with the yield on the 10-year T-note sliding to 3.84% by Friday from 4.07% on Tuesday. The yield is not far above its record low of 3.57% set on Oct. 9.
The rush back into longer-term Treasuries was partly attributed to some investors’ belief that the Fed is finished cutting short-term rates. If that’s true -- and if investors expect the Fed to hold at these levels for an extended period -- a natural response would be to shift money from cash accounts into longer-term bonds, to lock in yields.
Why might the Fed want money to flow into longer-term bonds? That could push mortgage rates lower, providing more support for the housing market, which has been one of the few pillars of strength supporting the economy this year.
Whether many more investors will decide they can no longer take the pain of holding cash in short-term accounts remains to be seen. For some, near-zero returns on cash still make more sense than taking the risk of deep losses on stocks or real estate (if the economy crumbles) or bonds (if the economy zooms, driving long-term rates up).
And as low as savings yields have gotten, they arguably aren’t as bad as in some previous eras, when adjusted for inflation.
In the 1970s, inflation, as measured by the Consumer Price Index, rose at a rate of 7.4% a year, according to data tracker Ibbotson Associates in Chicago.
In the same decade, the average annual return on three-month Treasury bills was 6.3%.
So adjusted for inflation, the return on T-bills in that decade was a negative 1.1% a year.
The current yield on three-month T-bills is 1.21%. CPI inflation over the last 12 months has risen 1.5%. If inflation stays at that rate, the annual after-inflation return on T-bills is approximately negative 0.3%. That’s lousy, but it could be a lot worse.
*
Tom Petruno can be reached at tom.petruno@latimes.com.
