When the 5% cash party ends, how will you meet tomorrow’s income needs?

by Nisha Thakrar, CFA

Like moths to a flame, soaring cash yields have seduced retail investors into pouring more than US$1 trillion in money market funds over 2023[1]. And with yields close to 5%, what’s not to like? Low effort income. Tick. Low risk. Tick. Easy access. Tick.

It’s not only retail investors. Investment professionals have also been tempted to look for extra income through cash, as the cost-of-living crisis unfolded. In fact, the sting of refinancing my mortgage has been sobering. If that wasn’t enough reason, fear of a recession has undoubtedly persuaded many of us to guard our savings tightly.

But for now, with UK and US inflation more than halved from their 2022 highs, interest rate cuts await us. The question for investors isn’t so much about when this will occur. Instead, how can they prepare for this because the 5% cash party is unlikely to last.

In other words, as we head into 2024 and beyond, will the large cash piles of 2023 still be justified? Or can other approaches help build future income with greater confidence?

No free lunch in the 5% yield club

A decade ago, the 5% yield club was a desolate place. Few assets could gain entry, often only higher risk equities. Yet aggressive interest rate hikes have swung open the doors to forgotten members. For example, cash and other lower risk assets like high-quality bonds (where investors lend to developed market governments and established global companies) have re-entered following a hiatus of almost two decades. But as most investors would expect, there’s no free lunch in the 5% yield club.

For example, while cash is not exposed to market moves, it has lost value in the long run, after adjusting for inflation. Conversely, high quality bonds have delivered positive long-term returns after inflation but with short-term fluctuations. The impact of these features over time, is better understood through an illustration. Imagine a couple, Zac and Maya. Their different decisions lead to them to stark fortunes over twenty years as the table below shows.

The damage of long run inflation versus the magic of compounding

But there is a silver lining in this. Their experience is a reminder that we all need to and can anticipate a significant proportion of our future income needs. When it comes to meeting those needs, we have a choice. Do we stay in cash and risk today’s rate falling tomorrow? Or do we consider the longer-term fixed income available from the bond market?

Tomorrow’s income needs

Predicting future interest rates shifts is tricky, especially with a frail economy. Bank of England economists estimate interest rates could fall to 4.25% in three years' time[2]. In the US, the Federal Reserve predicts 3.1% by 2025[3].  None of which are close to their 2% long-term inflation mandate. Meanwhile, savvy market commentators are divided. Some believe we are heading for trouble. Others say we may escape a recession altogether. Regardless of your level of pessimism, high interest rates are the putting the brakes on the economy.  That could lead to a long pause, or the beginning of a fall in interest rates.

Looking back at times when the Bank of England base rate was held steady or peaked, high-quality bonds consistently outperformed cash as shown in the charts below. This suggests current conditions could be favourable for high-quality bonds.

Peak or pause, bonds have outperformed cash 3 years on

Based on 3-year returns in GBP. Start dates shown on charts. Cash represented by ICE BoA Sterling 3-month Deposit Index and high-quality bonds represented by Bloomberg Global Aggregate Index (hedged to GBP). Source: Bloomberg, Morningstar

Move the excess cash before the 5% cash party ends

While today’s elevated cash yields are alluring, they are also at risk of collapsing in the near future - as they have done every time interest rates have peaked. This makes the number one job of cash meeting income needs for today.

For tomorrow's income needs, moving excess cash to high-quality bonds could lock-in long-term income.  Without needing to exit the 5% club.

Do you know when you need your income?

[1] As at September 2023. Source: Bank of America Securities, EPFR

[2] Based on the Monetary Policy Summary for November 2023. Source: Bank of England

[3] Based on FOMC projections as at December 2023. Source: Federal Reserve