Inflation surged past these yields, though they’ve started to rise again. Households nevertheless poured more money into them.

By Wolf Richter for WOLF STREET.

Despite inflation surging past short-term yields, households kept pouring cash into money market funds (MMFs) in Q1. Balances in MMFs held by households rose by $89 billion from the prior quarter, and by $626 billion from a year ago, to $5.21 trillion, according to the Fed’s quarterly Z1 Financial Accounts. Since Q1 2022, when the Fed started hiking its policy rates, balances have about doubled.

These MMF balances include retail MMFs that households bought from their broker or bank, and institutional MMFs that households bought indirectly through their employers, trustees, and fiduciaries – such as in their 401(k) plans.

MMFs are short-term liquid low-risk investments, a form of interest-earning cash: At current MMF yields of around 3.5% and at Q1 MMF balances, households would earn $182 billion in interest in a 12-month period.

MMFs have been earning around 3.5%, give or take a little, down from over 5% in 2024 before the rate cut started.

Treasury bills, a close alternative to MMFs, are currently earning between 3.66% (investment rate of the 4-week T-bills sold at auction this week) and 3.91% (investment rate of the 1-year T-bills sold at auction this week).

Inflation in March (end of Q1) was 3.5% per the Fed-preferred PCE price index, surged further in April, and in May went over 4.2%, and money market funds still earn only about 3.5%.

During January and February of Q1, MMFs were still out-earning inflation, earning a positive “real” yield (yield minus inflation). But that stopped in March for many MMFs, and in April for all MMFs, and further worsened in May. At May’s CPI inflation rate, “real” yields of MMFs are a negative 0.7%. They’re no longer attractive.

The Fed may eventually line up a rate hike or two, and the bond market currently expects the first rate hike to come late this year and another one next year, but that’s not guaranteed, that’s just the bond market pulling that way, and even if it does happen, real yields of MMFs would likely be negative until then, and might remain negative if inflation is allowed to stay at this rate or get worse still.

MMF yields are determined by the instruments they invest in minus the fees. Treasury MMFs stick to short-term Treasuries and overnight reverse repos at the Fed (ON RRPs). Prime MMFs invest in repurchase agreements (repos; Treasuries and agency securities with a remaining maturity of less than 1 year, but largely less than 3 months; short-term asset-backed commercial paper; certificates of deposits with big banks (lending to banks), ON RRPs at the Fed, among others.

Most of these instruments that MMFs invest in pay over 3.6% currently (except ON RRPs at the Fed, which is why ON RRPs have near-zero activity): Three-month Treasury yields are at 3.71%, six-month Treasury yields are at 3.80%. Asset-backed commercial paper is at about 3.75% for 30-day paper and 3.85% for 90-day paper. The difference between these yields and MMF yields are the fees extracted by the MMF provider.

At banks, large Time-Deposits (CDs of $100,000 or more) soared to a record $2.52 trillion in April, up by $49 billion from the prior month and up by $169 billion year-over-year, as per the Federal Reserve’s monthly report on bank balance sheets (H.8). The FDIC insures CDs up to $250,000.

Since March 2022, when the rate hikes began, large CD balances have surged by $1.11 trillion. The rate cuts starting in September 2024 pushed down the yields of CDs offered by banks and slowed the increase of the balances.

The higher inflation rates that give many of the CDs offered in March, April, and May a negative “real” yield, have not stopped or reversed the growth of CD balances – on the contrary, it seems, given the spike in April.

Banks have started to offer more attractive yields, especially on “brokered CDs” (bank CDs sold through stockbrokers) where they compete directly with other banks. I just checked at my broker: The top yields offered for CDs of 9 months or longer are all over 4% APY, so a slightly better deal than T-bills. These CDs that I looked at are not callable.

What those yields show is that banks are starting to expect rate hikes, and these banks are competing for deposits among CD buyers that are looking for deals.

Small Time-Deposits (CDs of less than $100,000) ticked up in April to $1.02 trillion, after declining for six months in a row, per the Federal Reserve’s separate data on money stock (H.6).

Since September 2024, when the Fed started cutting rates, balances have dropped by $172 billion.

Smalls CDs react fairly quickly and strongly to interest rates offered by banks. They’re not “sticky” at all. Investors shift into them and out of them depending on yields that banks offer. They’re sort of the hot money of CDs. When the rate cuts started and banks slashed their CD yields, CD balances fell. But even the small increases in yields recently caused balances to tick up again.

Inflation will be the challenge for investors in low-risk investments, such as MMFs, CDs, and Treasuries.

Inflation eats everyone’s lunch one bite at a time, sometimes more slowly, other times faster, whether real estate or stocks or bonds or cryptos or MMFs or CDs.

But some of the other investments come with the hope of big capital gains that will – hopefully, knock on wood – outrun inflation. And that has a history of working, and of not always working. If those investments have capital losses, the curse of inflation is added to the capital losses, making those losses even harder to swallow.

Other investments come with automatic “inflation protection,” such as Treasury Inflation Protected Securities (TIPS) and Treasury I-series savings bonds, which earn an inflation protection amount based on CPI that is added to the principal as it occurs, plus a low separate yield (“base rate” for I-bonds).

And by the looks of it, higher-than-2% inflation is here to stay. Neither this administration, nor probably the next administration, nor the Federal Reserve, nor Congress is unhappy with inflation in the 3-4% range or maybe in the 3-5% range. That type of inflation makes the fiscal mess the US is in a little less “unsustainable.”

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