There’s a faint but growing sucking sound permeating Wall Street. That is the sound of money being gradually sucked out of traditional investments like stocks and bonds and into money market funds.
A money market fund is a type of mutual fund that invests in highly liquid instruments including cash, cash equivalent securities, and high-credit-quality debt with a short-term maturity (such as U.S. Treasuries).
The amount of money stashed in money market funds recently rose to an all-time high of $5.4 trillion. After a string of positive weekly fund flows, it’s clear that more investors are noticing they can achieve satisfactory yields with minimal risk via money market funds.
The last two instances when money market fund flows accelerated this dramatically were in the leadup to the Covid market crash in 2020, and at the onset of the Great Financial Crisis in 2008. Both were recessionary environments.
Money market yields are largely guided by the Federal Reserve’s policy actions. Over the last year, the Fed has been rapidly pushed short-term interest rates higher to combat inflation. 3-month treasury bill rates are a useful proxy for money market yields. As you can see in the chart below, the current T-bill rate is near the highest level in twenty years.
High money market yields typically act as a headwind for risk assets. This is because capital flows to wherever it is likely to receive the best risk-adjusted return over time. High money market yields provide investors with a relatively safe alternative for their investment dollars.
When yields on money market instruments like Treasury bills, certificates of deposit, and commercial paper rise, active investors are more tempted to shift their capital from risky assets to safer options. This dampens the demand for risk assets and, in turn, puts downward pressure on their prices.
For example, in the months leading up to the 1987 Black Monday crash, investors were able to secure high single-digit yields on Treasury bills, which partly caused the shift out of equities into fixed-income instruments.
In the 1994 bond market massacre, the Federal Reserve unexpectedly raised interest rates multiple times, causing a sharp increase in money market yields. This led to a significant sell-off in both the bond and stock markets as investors shifted their assets to cash and cash equivalents, seeking safety from volatile markets.
More recently, money market flows accelerated when Silicon Valley Bank failed, which led to a cascade of solvency concerns across the broader regional banking landscape. If banks keep losing deposits to money market funds, this will certainly promote a ‘risk-off’ economic environment, because it increases the probability banks will dial back lending. That invariably slows money velocity throughout the financial system, which could be the catalyst that brings about the next economic recession.
A dash to cash is broadly evident.
“Cash is no longer trash,” says Jim Bianco. “That was a two-decade old meme that doesn’t apply,” the Bianco Research president told CNBC earlier this year. “Cash could actually be somewhat of an alternative where it was just a waste of time throughout the 2010s. It’s no longer that anymore.”
“You are going to get two-thirds of the long-term appreciation of the stock market with no risk at all,” added Bianco. “That is going to provide heavy competition for the stock market. That could suck money away from the stock market.”
Case in point: The Vanguard Real Estate ETF
Corporate bonds also have a hard time competing with 5% money market yields. The iShares Investment Grade Corporate Bond ETF
How about the favorite passive investment on the planet—the S&P 500? The S&P 500’s dividend yield is only a paltry 1.7%. But since many investors buy the broad stock market for its earnings growth potential, we could also look at the earnings yield. On this measure, the S&P 500 currently yields 5.0%. If you care about valuation risk, it’s worth noting the S&P 500’s earnings yield just dipped under the 3-month treasury yield for the first time in the last twenty years.
Takeaway: the S&P 500 looks richly priced versus cash.
The same can be said for most bonds and other risky investments, and this is by design. Part of the Fed’s job to squash inflation is to incentivize investors to migrate their funds out of economically sensitive assets. A negative wealth effect is part of the recipe for how we get back to 2% inflation someday.
Fight the Fed if you like. Valuation has never been a great timing catalyst, so maybe it will work out for you.
Personally, I’m not entirely out of the stock market. But I am certainly being a lot more selective nowadays. And I am loving the current opportunity to earn decent returns in a low-risk investment. It’s been a while since we’ve been able to do that.