Earning Nothing on Your Savings?
May 24, 2010
As you know, keeping your money in a savings account earns you very little. Where can you go to earn a higher rate of return, without the fear of losing value? Should you be concerned with inflation? Opinions vary, but read on for our thoughts.
Last year, moving funds from low-yielding savings accounts into bond funds was an easy and profitable move. It was an unusual opportunity with both municipal and corporate bonds providing higher yields. Now, bond funds are yielding less and money market rates are still paying near 0-percent interest. With the potential for higher interest rates on the horizon, what does the future hold for you? Here is our educated guess.
Cash Rates and Short-Term Rates: On the Rise
Will your savings account ever enjoy substantial earnings again? As of this writing, money market and savings accounts have been paying next to nothing for nearly 18 months. This is an unusual condition that is a direct result of the recent financial crisis. The interest rate paid on short-term investments (e.g., savings accounts, money market deposits and fixed-income investments that mature in less than one year) is driven by a rate set by the Federal Reserve (Fed) called the “federal funds rate.” During the height of the crisis, the Fed decreased the target federal funds rate to near zero to stabilize the financial system. Prior to 2008, this rate had not been below 1 percent since the 1950s.
Now that the economic recovery seems to be sustainable, the Fed will need to raise this rate to keep inflation at bay. While Chairman Bernanke assures us that the Fed will try to sustain low rates for some time, it is best to put this in relative terms. Before late 2007, the targeted federal funds rate was 5.25 percent. Relative to this level, the rate could be raised from 0.5 percent to 2 percent and still be considered “low.”
If this were the only change we face, it would be a pretty good scenario. Investors with longer-term investments would not be significantly impacted, and savings and money market accounts would start paying more interest shortly thereafter. Additionally, if you hold fixed-income investments maturing in less than one year, you will receive your funds in sufficient time to take advantage of the new higher rate without missing out on much of the increase in the interim.
Intermediate and Long-Term Rates: Could Go Higher
Whether intermediate and long-term interest rates will rise is less certain. We think that five- to ten-year interest rates, which are currently in the range of 2 percent to 6 percent, will also trend upward. This could cause an unexpected decline in the value of longer-term, fixed-income holdings.
Interest rates and bond prices have an inverse relationship, like a seesaw. As interest rates go up, the daily value of your bonds or bond funds typically goes down. The declines are far less severe than those of the stock market, and are associated with the amount of time it takes for your investments to mature.
For example, if you hold a bond with a maturity of three years and your principal and interest are paid in full at the end of that time, a 1-percent rise in interest rates will cause a 3-percent loss. At the end of the three years, you will still receive your full investment plus your interest due. However, if you need the funds prior to this point, you may be forced to sell your holding at a 3-percent discount. Therefore, the best thing you can do to counter this type of rate rise is to make sure the average maturity of your fixed-income portfolio matches the timing of your future withdrawal needs.
Inflation: Quiet for Now But Dependent on Fed
Finally, how concerned should you be about rising prices, otherwise known as inflation? Currently inflation is relatively tame. Over the next 12 months, much of what will happen on the inflation front will be dependent upon what the Fed does to unwind the significant measures taken during the heart of the crisis. If inflation increases, it could push intermediate and long-term rates even higher, increasing the potential for declines in fixed-income portfolios. In addition, inflation is like a long-term corrosive for all investments, especially cash investments. Using inflation-protection vehicles such as TIPS (Treasury Inflation-Protected Securities) and ensuring that your portfolio has a sufficient “growth” component, in the form of stocks, is your best protection.
Summary
To summarize, we think that both short- and longer-term rates will rise in the months to come. This will increase the interest earned from savings accounts, but may cause a decline in the value of longer-term bond holdings. Therefore, we suggest taking proactive steps in anticipation of these changes. And, while you should always plan for inflation, it is not presently a large concern.
