What to do with cash now that rates are lower?

The Fed has lowered the Fed Funds target by half a percent to 4.75% - 5.00%. This is the first drop since the Fed started raising rates after the pandemic in March of 2022. For most of the prior decade the Fed Funds rate had been at or near zero. 

The higher Fed funds rate led to high rates on debts such as mortgages and car loans, but it also led to higher rates on cash accounts such as savings accounts, CDs, and Treasury bills. 

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The one year T bill went from as low as 0.05% in March of 2022 up to as high as 5.26% in September of 2023. So for the first time in my nearly decade long career, investors were actually able to make a return on cash. 

This led to many conversations around lowering the risk of a portfolio since cash was actually making some money. 

But now that the Fed is lowering rates, what does that mean for these cash accounts? Well the 1 year T bill has already dropped down to 3.95% as you can see in the cart from Macro Trends above. It may take a little longer for banks to lower their rates, but I’d anticipate those dropping in the coming weeks and months as well. 

So with lower rates what should you do with your cash? 

My simple answer is that the changing rate shouldn’t have any affect on your cash. As long term investors, we don’t want to keep more cash than necessary. This is typically somewhere between 3 - 12 months worth of expenses plus the savings for any known big ticket items that will be spent in the next 2 years or so. 

Beyond that amount, cash should be invested and working for you in the market, even when rates are above 5%. 

There are two main reasons for this. 

First, we expect the market to outperform cash over the long run which it historically has. Even if you look at the period from October 31, 2022 when the 1 year T bill reached 4.75% until the Fed’s announcement on Wednesday, the S&P 500 has returned nearly roughly 50%. This was during a time when nearly all economists were positive we’d see a recession. By keeping more than necessary in cash you would have missed out most of that return. 

The second reason is tied in with the first, but it is the reinvestment risk of holding cash. Cash is a short term investment, which means it reacts quickly to the change in investment rates. As diversified investors we do want to hold some safer assets such as bonds to help lower the drawdowns of our portfolios, especially as we near retirement. In most years, the longer the maturity of a bond (meaning how long we need to hold it to get our money back, the higher the interest we’ll earn by holding that bond. So T bills typically will earn less than 2 year or 10 year treasuries. This is what’s known as the yield curve.

But back in 2022, the yield curve inverted. Meaning shorter term bonds such as the 1 and 2 year, were now paying more than what you’d get for holding the 10 year bond. The Fed Funds rate affects the short end of the yield curve. So lowering the Fed Funds rate is helping revert the yield curve. 

So while we were able to get 5%+ on our cash over the last 2 years, now as those T bills mature or the rates on our savings accounts drop, we won’t be able to reinvest the money at the same rate. And if it’s money that we needed to earn 5% over time for our financial plan, then we may have also missed out on a good portion of the market returns. 

This is why it is important to ignore most of the headlines when you are setting up your portfolio. Holding cash is important to weather the inevitable storms that will arise, but holding too much is a drag on the performance of your portfolio and will lead to lower returns long term. 

Hopefully this is just a reminder as to why we don’t try to time the markets, but if this has you questioning your portfolio allocation I’d be happy to have a discussion on what makes sense for your personal plan.