Just when a little spark has returned to money market mutual funds, things are about to get complicated.
For almost a year now, yields on these packages of short-lived securities such as Treasury bills and commercial paper have staged a nice, steady recovery toward respectability as the Federal Reserve has raised short-term interest rates.
The average yield on money funds, which scraped bottom at about 0.5 percent in April 2004, has climbed back to a 31/2-year high of 2.44 percent as of May 31 at last report by researchers iMoneynet in Westborough, Mass. It figures to go higher still, especially if on June 30 the Fed posts another quarter-point increase, to 3.25 percent, in the overnight bank rate.
Here's the rub: With each basis point, or hundredth of a percentage point, that money rates increase, they move closer to medium- and long-term rates that have been rising less sharply or not at all.
If Fed policymakers, who have raised short-term rates 25 basis points at each of their last nine scheduled meetings, were to keep doing that, the target rate would reach 4 percent by Nov. 1.
That would be about 40 basis points higher than the recent yield on two-year Treasury notes, and within 10 basis points of the recent yield on 10-year notes.
The resulting contortions in the yield curve, or graph of interest rates across various maturities of interest-bearing investments, would raise a commotion well before it reached that point. Inverted yield curves, or situations in which shorter-term rates exceed longer-term ones, have a well-earned reputation as harbingers of economic trouble.
Since buyers of longer-term securities take more inflation and interest-rate risk, it stands to reason that they should get paid more. "In normal times, the yield curve should slope upwards," said David Kelly, senior economic adviser at Putnam Investments. "A downwardly sloping yield curve is ominous."
In the past 50 years, Kelly recently wrote, the yield curve has been inverted in 42 quarters, or 21 percent of the time. Economic growth, as measured by inflation-adjusted gross domestic product, averaged just 1.1 percent in the following years, compared with 4 percent in other years. "Two-thirds of the inverted yield curve episodes over the last 50 years have been followed by a recession within two years," Kelly said.
To keep the yield curve from inverting, one of two things -- or a combination of both -- must happen. Either short-term rates must stop rising so steadily, or long-term rates must go up.
None of the possibilities looks especially bright for money-fund investors, who may still harbor memories of yields at 6 percent or better as recently as the year 2000. If the Fed throttles back on its interest-rate increases, ipso facto that means a slowing in money funds' comeback.
Long-term rates have stubbornly refused to rise in the bond market. If they do that now, they presumably will act as a brake on the economy, thereby reducing the prospects for future Fed increases in short rates. If the yield curve inverts, the economic trouble that portends would raise the odds of lower, not higher, short-term rates down the road.
Kelly said he doesn't expect the Fed to tip the yield curve into inversion any time soon.
"The most likely scenario is that the American economy will continue to grow at a steady pace and the Federal Reserve will only have to metaphorically take its foot off the gas rather than apply pressure to the brakes," he wrote.
Kelly's thought was echoed by Anthony Chan, senior economist at J.P. Morgan Asset Management in New York, who said, "The central bank may very well end up raising short-term rates a lot less than previously feared due to slowing, but not contracting, growth trends."
No matter what, the going is likely to get much tougher soon for the comeback of money-fund yields. The prospect of chronic low returns, so widely lamented in many bond and stock market outlooks, is an issue for money-fund investors too.