This is Where to Find Yield Now.
Two months ago, 1-5 year CDs were paying 5% or more. Today yields are in the 3.8-4.25% range. The author suggests that investing for income just got simpler.
By John H. Robinson, Financial Planner (August 29, 2024)
Two months ago, we were able to lock in 5% yields to maturity on new issue CDs as far out as five years. One-year rates peaked as high as 5.3%. Now the best five year rates are around 3.8% and the one year rate is sitting at around 4.25%.
What Caused CD and Bond Yields to Drop?
Since early 2022, I have cautioned investors to ignore the bond market forecasters who consistently mis-interpreted Fed Chairman Powell’s hawkish comments to mean that a slew of rate cuts were in the offing. Instead, I encourage our clients and other readers of this newsletter not to overthink Mr. Powell’s comments on the outlook for inflation and to simply take them at face value.
Prior to the Fed’s August (2024) meeting several economic indicators seemed to finally be signaling that inflation has cooled and is on target for the Fed’s stated 2% goal. This data was not lost on the bond market, and rates began falling in earnest in early July – well before the Fed’s Open Market Committee meeting. At the meeting, Mr. Powell acknowledged the positive trend toward the Fed’s target, but stopped short of committing to a rate cut at the next FOMC meeting in September.
However, in a press conference on Friday, August 23, Mr. Powell confirmed that the Fed will be announcing a cut in the Fed Fuds rate at the September FOMC meeting. He did not indicate the magnitude of the cut.
How to invest for yield now? Fixed income investing just got simpler.
As I have said all along, it is wise to “listen to the Fed.” Mr. Powell has indicated that inflation appears to be tamed and that the Fed is planning to cut rates. From that, I believe it is safe to conclude that we have seen the last of 5% yields on CDs (and treasuries and agencies) for a while.
For the past 2 years I have been encouraging our readers with new money or maturing bonds and CDs to extend maturities as far as they could to lock in 5% yields. As recently as May 2024, we could get 5% as far out as 5 years. Congratulations to those who followed that advice.
For investors who have maturing CDs or other cash to reinvest, investing for yield is now much simpler. My advice is to allocate your bond dollars to a U.S. Treasury money market fund. As with all money market funds, treasury money market funds are liquid (funds are available on a T+1 basis) and are tasked with maintaining constant $1.00 per share value. The latter is achieved by purchasing treasury securities with short maturities (typically less than 60 days). Since short term treasuries are still paying north of 5%, investors in Treasury money funds may still capture most of this yield.
Further, assuming your Treasury money market fund invests exclusively in U.S. Treasury securities, the interest earned may be exempt from state income tax. This is a meaningful yield boost if you live in a state with a high income tax such as Hawaii, California, or New York.
[NOTE: In considering a Treasury money market fund, it is wise to read the fact sheet or prospectus to ascertain if the fund invests only in treasuries or if it purchase other cash equivalents such as repurchase agreements or agency securities that may not be exempt from state tax. Just because a money market fund has “government securities” or “Treasury” in its name does not necessarily mean that invests exclusively in U.S. Treasury securities].
Yields on Treasury money market funds (and all other money market funds) fluctuate with interest rates. I fully expect that the yield on Treasury money market funds to decline commensurate with the Fed’s lowering of the fed funds rate from 5.25-5.5% to something lower. However, with the 12-month CD rate languishing at around 4.25%, it would take a series of hikes for the 12 month return on a Treasury money market fund purchased today to under-perform a 1 year CD purchased today.
The Outlook for Bond Yields
Although the Fed’s decision to begin cutting interest rates seem to suggest that the Fed has been remarkably adroit in managing its dual goals of keeping inflation under control without triggering a major recession. However, this successful policy intervention does not signal a return to stability and normalcy in the bond markets.
In fact, the yield curve remains inverted and has been in this peculiar state since July 2022 – the longest period in history. In theory, this state is paradoxical – If someone wants to borrow money from you, the interest rate you charge for the loan should be higher the longer your money is out of your hands. In the current economic environment interest rates on short-term bonds are higher than longer term bonds.
In previous commentaries, I have noted that many bond market prognosticators believe that the yield curve will return to its normal shape when short term rates return to 2021 levels. I do not agree with that forecast. I believe the interest rates in 2021 and much of the prior decade were a historical/generational anomaly. I continue to believe that short term yields on CDs and treasuries are unlikely to fall much below 4% with 3% being an unlikely low. I believe intermediate and longer term yields (e.g., 10 year treasury and 30-year treasury) will eventually trend up to 5% and 6% to bring the yield curve back to normalcy.