Investors have recently been embracing an asset class that in years past hasn’t received much attention at all: money market funds.
Indeed, flows into money market funds have been soaring over the past several months. By the end of Q1 2023, cash parked in money market funds grew to a record-high $5.7 trillion, following several weeks of positive fund flows. As the chart below shows, the last two occasions when cash in money market funds increased so substantially was before the 2008 Global Financial Crisis and again before the pandemic.1
Total Assets in Money Market Funds
Source: Federal Reserve Bank of St. Louis2
As a quick refresher for readers, money market funds are a type of mutual fund that invests in various liquid instruments, like cash, short-term U.S. Treasuries, cash equivalent securities, and others. For this reason, they are largely considered safe, but they are not risk-free like U.S. Treasuries. And since money market funds are generally managed, they also tend to have expense ratios associated with them – which can cut into returns slightly.
There’s a pretty straightforward reason money market fund flows have jumped substantially over the past several months. It’s because yields have gone up substantially, too. A good proxy for money market yields is the 3-month Treasury bill, which is primarily guided by Federal Reserve monetary policy. 2023 has also been unique for short-duration T-bills because of the debt ceiling standoff, the uncertainty of which drove yields even higher. All told, and as seen in the chart below, 3-month Treasury bills have seen a historic surge in yields, which has also pulled money market fund yields higher.
Source: Federal Reserve Bank of St. Louis3
With many money market funds now sporting yields of ~5% or higher, active investors increasingly see ‘cash’ as a viable asset class next to equities, bonds, real estate, etc. And for investors wondering if this could act as a headwind for risk assets in the near term, the answer from a historical perspective is yes.
Two examples come to mind. In the lead-up to the 1987 Black Monday Crash, short-duration T-bills were paying high single-digits, which many historians would argue contributed to a rapid shift out of equities and into fixed income. There was also the 1994 bond market crisis when the Fed quickly and unexpectedly raised interest rates at several meetings, which in turn drove up money market yields and led to a sharp shift away from stocks and bonds and into cash.
What’s notable about these two examples – and the point I want to drive home to readers – is that both events resulted in market corrections, not prolonged bear markets. The real insight of money market fund flows, in my view, isn’t that higher yields may result in stock and bond market volatility. It’s that surging levels of money market funds tell us how much cash is available to flow into risk assets on a forward basis. In my view, more cash on the sidelines equates to more ammo for future returns in risk assets. Money market yields may be attractive now, but they don’t size up to risk-adjusted long-term returns investors have historically earned from stocks.
Some of the historical numbers bear this point out. In the years following the 1987 Black Monday Crash, the S&P 500 rose +16.54% (1988) and +31.48% (1989), and following the 1994 bond market crisis, stocks were up +37.20% (1995), +22.68% (1996), and +33.10% (1997). Money market funds were in those cases a viable alternative to stocks, as they are now, but they did not serve as headwinds for long.
Bottom Line for Investors
Higher yields in money market funds and short-term Treasury bills are largely by design. The Federal Reserve’s goal is to lower inflation, and part of that job entails trying to get investors to move funds away from economically sensitive assets. Recent trends in money market funds suggest the Fed’s actions are having an effect, but forward-looking investors should see the data in another light—more cash on the sidelines means more cash available to invest in risk assets over time.
Disclosure
2 Fred Economic Data. June 8, 2023. https://fred.stlouisfed.org/series/MMMFFAQ027S#
3 Fred Economic Data. June 13, 2023. https://fred.stlouisfed.org/series/DTB3#
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