by Blaine Dickason
Senior Vice President Portfolio Management and Trading
With the Federal Reserve taking a ‘higher-for-longer’ approach to interest rates, bond yields are higher than what the market expected at the start of the year. Recent sales of U.S. Treasuries needed to cover the persistent deficit between federal spending and revenue are carrying attractive coupon rates reflective of this current interest rate environment. Considered together, higher coupon rates being paid on a larger stock of debt means that interest income paid to bondholders has climbed to record highs. Just in the month of March, the U.S. Treasury spent nearly $89 billion for interest costs on our public debt. As a recent Bloomberg article calculated, bondholders were paid interest income at a rate of nearly $2 million a minute!
Interest rates have risen from near-zero to now over 5% on short-term Treasuries over the last several years. As low-coupon bonds issued during the pandemic mature, the U.S. government is forced to refinance that borrowing at current interest rate levels, contributing to a marked increase in interest costs in our federal budget. In just the last several years, the average interest rate on our debt has more than doubled, from under 1.6% to just over 3.2%. What appears as interest expense for our federal government, however, is matched by interest income being paid to bondholders. Given the present level of income that Treasuries are now providing, and a state tax deduction on interest earned that can be meaningful in high-tax states, these bonds may have finally returned to their traditional role of providing steady and predictable income to investors’ portfolios for years to come.
Higher interest rates have also lured record levels of cash into money market funds (short-term liquid investments that serve as a cash equivalent). As seen in the chart above, total assets in these money market funds now exceed $6 trillion after tremendous growth last year. With many yielding close to 5%, these funds are providing individual investors with the opportunity to capture much of the benefit of higher rates with their cash balances, rather than ceding that income to their financial institutions if kept in traditional deposit accounts.
The current interest rate environment has emphasized a couple of things in our mind. First, investors need an intentional plan for cash management, or risk both a loss of interest income and an erosion of purchasing power to inflation. Second, as short-term yields will be the first to decline when the Federal Reserve begins cutting interest rates, investors should not be seduced into over-allocating to these cash equivalent vehicles at the expense of your long-term asset allocation strategy.
Inflation Report Next Week
This coming Wednesday, the Bureau of Labor Statistics will release its Consumer Price Index (CPI) report for the month of April. Current expectations are for it to remain stubbornly above 3%, although slightly lower than reported the prior month. The Federal Reserve has made it clear they need to see more evidence that inflation is on a sustainable path to return to their 2% target. Next week’s report will go a long way to inform current market expectations for either one or two interest rate cuts in the second half of this year.
Takeaways for the Week
Wednesday’s 10-year U.S. Treasury auction was awarded at a 4.48% yield. This is important for student loan borrowers as interest rates for new undergraduate loans are pegged at 2.05% over the yield realized at this auction every year. Borrowing costs will be a full percentage point higher than last year
Over 90% of the S&P 500 have now reported first quarter financial results. To date, both company revenues and earnings have grown by approximately 4%, with each exceeding their respective estimates entering this latest earnings season