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The Cost of Cash: A $6 Trillion Question

In this PIMCO Perspectives, we examine how the return of elevated bond yields comes at an opportune time to consider shifting out of cash.

In 2023, Bruce Springsteen kicked off a year-long U.S. tour. However, after a concert at the Meadowlands in New Jersey in September, he had to cut the tour short due to a health problem. Not one to let his fans down, he took time to recover and rescheduled the canceled dates for 2024. Now, Bruce is back, thrilling fans who didn’t get to see him last year with epic three-hour sets – including a memorable April performance here in Southern California.

There is a parallel today between the Boss and the bond market. Like Springsteen’s fans who are enjoying a second chance to see him perform, investors who missed out on last year’s peak bond yields are now getting another shot as yields reach levels not seen since last fall.

The yield on a 2-year Treasury note briefly peaked in October 2023 at around 5.2% before falling by more than a percentage point over the next few months. Thanks to a string of strong economic data, sticky inflation, and a broader theme of American exceptionalism, the 2-year Treasury yield recently rose above 5% again. The best part for investors: This rise comes at an opportune moment to consider moving out of cash and locking in longer-term bond yields. Let’s explore why.

Sitting on the sidelines

There is currently over $6 trillion of cash parked in money market funds (see Figure 1). This is double the average for the past 30 years. The clear benefit of cash is its perceived safety. But the potential drawback is its opportunity cost. With cash out-yielding the bond market – albeit by a meager 20 basis points (bps) – some have concluded that “cash is king.”

Figure 1: Money market fund balances have surged

Figure 1 is a line graph showing money market fund balances from 1990 until the present, according to the U.S. Federal Reserve. The balances start at about $400 billion in 1990 and climb gradually toward $2 trillion in 2008. They rise above $3 trillion in the aftermath of the financial crisis in 2009 before dipping back below that level for about a decade. They then surge to about $5 trillion at the start of the pandemic, hold steady through 2022, and then rise to a peak of about $6.3 trillion in early 2024.
Source: Federal Reserve as of 23 January 2024

We disagree. We believe many investors have lagged in their response to a shifting monetary cycle, perhaps scarred by the extreme inflation spike in 2022. Nearly two years later, they remain over-allocated to cash and over-exposed to high and rising opportunity costs.

Historically, cash has almost never outperformed bonds at this stage of the cycle, with policy rates at peak levels and the Federal Reserve poised to cut. Only in 1981 did bond investors have to wait a little more than a year from the initial rate cut to outperform cash.

In all other cycles dating back to 1980, it took a year or less for bonds to outperform cash. And not by a little. On average, core plus bond portfolios (or short and intermediate maturities) outperformed cash (as gauged by 3-month T-bills) by about 5 percentage points over the year following the peak in the federal funds rate (see Figure 2), and by about 4.5 percentage points annualized over the ensuing three years.

Figure 2: Performance across hiking cycles

Figure 2 is a bar chart showing performance of 3-month T-bills, short term bonds, core bonds, and core plus bonds across Federal Reserve rate-hiking cycles. T-bills are proxied by the Citigroup index, and the other asset classes are proxied by Morningstar categories. The first of three sets of bars shows performance one year prior to the peak federal funds rate, with T-bills outperforming the other asset classes. The second set shows performance one year after the peak fed funds rate, and the third shows annualized performance for three years post-peak rate. In both of those scenarios, all categories of bonds outperform T-bills, led by core-plus strategies. Hiking cycles are defined as periods where the Federal Reserve embarks on a sustained path of increasing the target fed funds rate and/or target range. We define the end of a hiking cycle as the month where the Fed reaches its peak policy rate or range for that cycle. Hiking cycles encompassed began in 1980, 1983, 1988, 1994, 1999, 2004, and 2015.

As of 31 March 2024. Source: PIMCO, Morningstar, Bloomberg, T-Bills: Citigroup 3-Month US T-Bill Index; Short-Term: Morningstar Short-Term Bond Category; Core Plus: Morningstar Intermediate Core-Plus Category; Core: Morningstar Intermediate Core Category.

Hiking cycles are defined as periods where the Federal Reserve embarks on a sustained path of increasing the target fed funds rate and/or target range. We define the end of a hiking cycle as the month where the Fed reaches its peak policy rate for that cycle (i.e., it either pauses rate hikes or cuts). Hiking cycles include (start to peak), 1980 (Jul '80 to May '81), 1983 (Feb '83 to Aug '84), May 1988 (Feb '88 to Mar '89), 1994 (Jan '94 to Feb '95), 1999 (May '99 to May '00), 2004 (May '04 to Jun '06) and 2015 (Nov '15 to Dec '18).

Past performance is not a guarantee or a reliable indicator of future results.

This makes sense. Mathematically, it doesn’t take much for bonds to outperform cash given their higher duration, or greater sensitivity to interest-rate changes. A yield decline of just about 80 bps has the potential to generate price appreciation and lead to a portfolio of short- and intermediate maturities doubling the return of cash (in line with the historical average).

Perhaps the only thing holding investors back from deploying that cash is the possibility that the Fed is forced to reverse course and hike (not cut) rates – an understandable concern. In this scenario, likely premised on another inflation spike, the fed funds rate would not have peaked yet and the yield curve would continue to invert, potentially giving cash an even greater benefit over bonds.

However, we think this is unlikely. Recent data have clearly surprised to the upside on growth and inflation, which might delay pending rate cuts, but we still believe the Fed is keen to start normalizing monetary policy this year. After last week’s policy meeting, Fed Chair Jerome Powell emphasized that rates remain restrictive and said another hike was “unlikely” at this point. In addition, China is overproducing and now exporting deflation to much of the global economy.

As we noted in our last PIMCO Perspectives, we remain wary of longer-dated Treasury maturities given elevated supply, debt dynamics, and a lack of an appropriate term premium (for more, see “Back to the Future: Term Premium Poised to Rise Again, With Widespread Asset Price Implications”). At the same time, yield curve inversions have not lasted long historically. We can identify 12 distinct inversions going back to the 1970s. On average, these rare episodes lasted about seven months. The current one has already endured for about two years. The longest previously, in 1978–1980, lasted 20 months. We are late in the game indeed.

Analog for investors

In 2021, when bond yields first hit rock bottom, we spoke to many savvy chief financial officers who issued debt and termed out their liabilities, locking in historically low borrowing costs by issuing longer-dated debt.

There is an analog at this point in the cycle for investors: Consider doing the same with your assets. Consider seeking to lock in higher yields now before the cycle turns once again. Cash rates are only guaranteed overnight and are set to fall when the Fed ultimately starts cutting rates. Terming out and locking in could be a savvy strategy for investors as well.

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