While there has been talk of interest rate cuts for virtually all of 2024, it seems as though we may be fast approaching that prediction becoming a reality. This has clients rightfully asking what actions they should take regarding cash liquidity in the coming months. Let’s take a look

The challenge facings my clients, and virtually all investors, is that once the Federal Reserve starts cutting interest rates, the 5%+ rates they have been enjoying on cash equivalents (such as money market funds) will fall in lock-step with the short-term rate curve. The ability to earn 5% on “safe” investments has always been known to be a temporary phenomenon as short-term rates were only kept at these levels to combat inflation. However, after two years of this dynamic, it can be hard to admit the party is about to end.

Rates of cash equivalents won’t fall to zero overnight – and they likely won’t fall to zero at all. The Fed will likely cut until short-term rates approach 3%. But still, that is a meaningful decline from today’s levels and leads to a need to assess the placement of cash liquidity.

In talking with clients, I’m encouraging them to segment their cash balances into a few buckets. Let’s look at each one and the related actions you may wish to take

Emergency funds – as we’ve discussed in the past, it is prudent to maintain a set amount of cash at all times. Call it an emergency fund or cash reserves but the idea is the same. This is cash you keep for the unforeseen and unpredictable occurrences – ranging from more minor items like car or home repairs and more severe such as loss of job or illness. These funds should be kept in cash equivalents (like a money market fund) so they are always liquid and available to you – and not subject to market gyrations. The nature of an emergency is that it is unpredictable and as a result, these funds need to be maintained in an instrument you can access – regardless of prevailing interest rates

Near-term expenses – it’s also a best practice to earmark and save cash for known upcoming expenses, such as a home renovation, car purchase, tuition payment, etc. Once you know an expense is on the horizon, you want to ensure you have the funds available when they’re needed and not subject to market fluctuations in between. As rates on money market funds are poised to fall, you may wish to evaluate the investments you use for these funds but be sure to match the duration of the investment to the timeframe of the cash outlay. For instance, if you have an expense coming up in 9 months, you could look at available rates on bank CDs or US treasuries with a 9 month term. While the current rate on those instruments may be below a money market fund, it’s likely that by the time 9 months is up, the rate on those instruments may be higher than what you yield on the money market fund

Remaining cash allocation – After you have taken emergency funds and near term expenses into account, the remainder of an investor’s cash allocation is mostly in place for target asset allocation reasons. We always allocate a certain amount of the portfolio to cash to help manage volatility of the portfolio – and to manage clients’ fears during a downturn. By having enough cash on hand (say 1-3 years of living expenses) within the invested portfolio, clients are less concerned about daily gyrations of the market and less apt to take action (like selling) at the worst possible time. For this portion of cash, we have been diversifying clients a bit. While we are keeping some funds in money market accounts, we are also using bond ladders to a larger extent. Bond ladders are where you invest funds in various bond maturities (3 months, 6 months, 1 year, 18 months, 24 months). Again, these instruments are paying less interest than money market funds are today – but there is major reinvestment risk to money market funds (ie: you won’t be able to reinvest funds in a money market at today’s rates within a matter of months). Ladders also allow funds to mature at frequent intervals which helps with any liquidity needs

As you can see, there are many factors to consider when evaluating cash (and other investments) in the face of falling interest rates. We advise you consult with your advisors and evaluate your situation individually. Happy cash sorting!