The interplay of risk and inflation.

By Wolf Richter for WOLF STREET.

Yields of money market funds, currently below 3.75% after fees, aren’t as attractive as they were in the first half of 2024 when their yields went over 5%. Nevertheless, households have further increased their holdings.

Balances in money market funds (MMFs) held by households rose by $63 billion from the prior quarter, and year-over-year by $579 billion, or by 12.8%, to $5.1 trillion in Q2, according to the Fed’s quarterly Z1 Financial Accounts. Since Q1 2022, when the Fed started hiking its policy rates, balances have more than doubled.

Balances include retail MMFs that households bought directly at their broker or bank, and institutional MMFs that households hold indirectly through their employers, trustees, and fiduciaries – such as in their 401(k) plans.

Total MMF balances, including those held by households and institutional investors, rose by $152 billion in the quarter and year-over-year by $960 billion, or by 12.8%, to $8.4 trillion:

MMFs invest in short-term liquid securities with a remaining maturity of less than 1 year, but largely less than 3 months. Prime MMFs invest in repurchase agreements (repos), Treasuries, agency securities, asset-backed commercial paper, certificates of deposits with big banks (lending to banks), and overnight reverse repos at the Fed (ON RRPs), among others. Specialized Treasury MMFs invest in Treasuries and ON RRPs. Municipal MMFs, which people buy for tax reasons, invest in short-term municipal debt.

Treasury bills bought at auction and held at brokers, where they can be set up on automatic rollover, are a close alternative to MMFs and similarly liquid. They generally don’t involve fees, and so their yields can be as good or better than MMF yields after fees.

Today, the government sold 6-month T-bills at the auction at an “investment rate” of 4.20% or a “high rate” of 4.06%. In the secondary market, the 6-month yield traded at 4.18% today.

The government also sold 3-month T-bills today at an investment rate of 4.07% or a high rate of 3.97%. In the secondary market, the 3-month yield traded at 4.04% today.

Yields of MMFs will tick up over the next few weeks to reflect those T-bill yields if the Fed hikes its policy rates on Wednesday.

The bond market has been clamoring for a rate hike, and traders have priced in a rate hike, so all it would take is for at least 7 of the 12 voting members of the FOMC to vote for a rate hike. But at the last FOMC meeting in July, when the bond market had already priced in a rate hike, only 3 of the 12 members voted for a rate hike, and there was no rate hike.

But in “real” terms (after inflation), MMF yields have been meager to negative as consumer price inflation has been running slightly below or slightly above MMF yields this year. The Consumer Price Index pegged inflation at 3.4% year-over-year in August; the PCE price index, which the Fed favors, pegged inflation at 3.7% year-over-year in July.

Large Time-Deposits at banks (CDs of $100,000 or more) rose by $160 billion year-over-year to a record $2.56 trillion in August, as per the Federal Reserve’s monthly report on bank balance sheets (H.8). This includes CDs that MMFs hold. The FDIC insures CDs up to $250,000.

Since March 2022, when the rate hikes began, large CD balances have nearly doubled. Starting in September 2024, the growth rate slowed after banks reduced their CD interest rates in response to the Fed’s rate cuts. But growth re-accelerated this year among slightly higher rates.

Small Time-Deposits (CDs of less than $100,000), a favorite with savers, are very interest-rate sensitive, as the chart below shows. After the peak of short-term interest rates in the first half of 2024, balances declined but then stabilized at around $1.5 trillion, with almost no change for the past seven months, per the Federal Reserve’s separate data on money stock (H.6).

Since the peak in September 2024, when the Fed started cutting rates, balances have dropped by $128 billion.

Many CDs are currently being offered with rates of 4% and higher. Retail investors can buy CDs directly from their banks or through their brokerage accounts (“brokered CDs”).

The interplay of risk and Inflation. Inflation isn’t going back into the bottle, and for investors in low-risk instruments, such as MMFs, CDs, and T-bills, that’s a problem at current yields.

Inflation is a problem for all assets as it eats purchasing power in equal measure. But the hope is that either asset prices themselves rise faster than inflation, or that the yield is higher than inflation, or both, thereby compensating investors for the loss of purchasing power due to inflation, plus some, hopefully, knock on wood. But that’s a hope and is not always the case.

It hasn’t been the case in the overall housing market since mid-2022, with the national median home price rising at a much slower rate than inflation, thereby losing ground to inflation. From mid-2022 through August 2026:

• National median price, single-family homes: +3.3%.
• Consumer Price Index (CPI): +13.3%.

Stock prices have pulled far ahead of inflation so far in this cycle, but the risks are big, and long sell-offs are not uncommon, and then those capital losses are made worse by the loss of purchasing power due to inflation.

The S&P 500 plunged by 50% and the Nasdaq Composite by 78% during the Dotcom Bust from their March 2000 highs. They plunged again by 50% during the Financial Crisis through March 2009.

It took the Nasdaq till 2015 to get back to its March 2000 high – after 15 years that included lots of money printing by the Fed.

But over those 15 years, there was 39% CPI inflation, so in “real” terms (adjusted for inflation), the Nasdaq was still down by 39% in 2015 from the March 2000 high.

In 2018, when the Nasdaq had just broken even in “real” terms with March 2000, there was another sell-off that pushed the Nasdaq back into the negative, adjusted for 47% inflation since March 2000.

Then came the covid crash that knocked the Nasdaq back into the negative in real terms, adjusted for 51% inflation since March 2000.

It wasn’t until April 2020, that the Nasdaq soared past its inflation-adjusted March 2000 high. It took 20 years in real terms!

But then over the past 6 years, the gains, adjusted for inflation, were huge. That is the interplay of “risk” and “inflation.”

So stocks and real estate are in entirely different risk categories – with big potential gains and losses – than highly liquid, short-term yield investments, especially those with government backing (T-bills and FDIC-insured CDs), with nearly no risk of capital losses, essentially no chance of significant capital gains, and only relatively low yields.

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