by Matt Tourville, Investment Adviser
In the world of finance, it’s common to hear the phrase “a dollar today is worth more than a dollar tomorrow.” If you want one dollar at a certain time in the future, you will need some fraction of that dollar today and invest it for the time needed for the amount to grow to a dollar. It’s what we all know simply as the time value of money.
Yet, what we have long perceived to be a basic financial truth has been turned on its proverbial head over the last 15 years. Across the globe, interest rates hovered near zero, or even dipped into negative territory at times. Quite literally, you would get back less than a dollar for the privilege of investing it – even for years. Once zero interest rate policies largely disappeared, inflation quickly became the bane of all savers here in the United States. The destructive power of inflation similarly makes a future dollar worth less than one today.
Even as short-term interest rates have risen to their highest levels in nearly a generation, that renewed earning power has been outmatched by the highest inflation rates of the past 40 years. Increased income on invested assets has been easily overcome by the diminished purchasing power associated with persistent inflation.
What we’re really talking about here is the concept of real versus nominal rates. Nominal rates are the stated yields at which fixed-income investments are purchased, whereas real rates are nominal yields net of inflation. In the simplest terms, it means if you took all your savings and purchased a one-year Treasury bill with a nominal yield of 4.00% and inflation for that same period is 6.00%, the real yield on your investment is -2.00%. You’ll have more money in nominal terms when your investment matures, but it’s now worth less in real terms when compared to the increased cost of goods and services. When real yields are negative, our accumulated wealth fades with each passing day.
Other than for a brief period in 2020, real short-term rates (think money market and near cash investments) were negative for nearly two full years, reaching as low as almost -7.50%. Then, in 2023, real yields finally turned positive due to a combination of increases to the target range of the federal funds rate to its present 5.25% – 5.50% and inflation falling below 4.00% (annually). The August read on inflation, as measured by the annualized Consumer Price Index was 3.70%. In basic terms, the real rate of interest on short-term money is approximately 1.60% – 1.80%. The one-month real rate, as reported by the St. Louis Federal Reserve Bank, crossed into positive territory in December of 2022 and reached a peak of over 5.00% in June of this year, its highest since 2009. Real yields have since retreated and the one-month measure now stands at roughly 2.50%.
The question now is this: Has the fire-breathing dragon that is inflation truly been slain? We will only know in hindsight, of course, but the trajectory of most price measures indicates that inflation is falling, albeit slowly and nowhere near the Federal Reserve’s stated goal of 2.00%.
At the conclusion of the Federal Reserve’s Federal Open Market Committee (FOMC) meeting on Wednesday, September 20, the FOMC stood pat on the current target range for the federal funds rate. In his standard post-meeting address, Fed Chair Jerome Powell’s statements reinforced the notion that policymakers are committed to keeping the fed funds rate “higher for longer.” Chair Powell remarked, “We want to see convincing evidence really that we have reached the appropriate level, and we’re seeing progress and we welcome that…We need to see more progress before we’ll be willing to reach that conclusion.” Additionally, projections that include FOMC members’ forecasts of the future federal funds rate pointed to one more quarter-point increase this calendar year. Whether that holds true remains to be seen and will be largely dependent on economic data during the last quarter of 2023. Probabilities derived from federal funds futures pricing indicate expectations of holding fed funds higher than 4.00% for all of 2024.
Are we at a turning point? We’re certainly not all in on that bet. However, public funds investors will soon need to contemplate how long they’re willing to ride the short end of the interest rate curve versus seeking opportunities to extend maturities in an effort to achieve more durable income over a longer horizon. From an income perspective, cash is a volatile asset class that does not lend itself to predictability. Additionally, the “normal” term structure of interest rates is positively sloped, with positive term premium for longer investment periods. If intermediate- and long-term interest rates rise, there’s no guarantee short rates will stay as high as they are today. It’s unlikely any one of us will be able to recognize the perfect moment in time when market forces shift direction.
Today, a balanced approach to investing is more likely in order, one that doesn’t also lead to undue interest rate risk at the portfolio level. If you’re heavily weighted towards cash and ultra-short maturities, it might be time to get “real” and think about your income-producing assets with an eye towards the future. If you’d like to discuss your specific investment needs and goals, don’t hesitate to contact Ehlers’ Investment Advisers.
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