Risk-Free Returns is the soup du jour…at least for now

A risk-free rate of return is just as it sounds. An investment instrument that provides no risk, principal protection, and, often, a higher fixed rate of return when compared to standard checking and savings accounts. There are three main places an investor can find a virtually risk-free rate:

1. Money Market accounts
2. Certificate of Deposits
3. U.S. Treasury Bills, Notes and Bonds

For the purpose of this market update, we will focus more on Certificate of Deposits (CDs) and U.S. Treasury Bills.

We are all familiar with how CDs work. Give your money to the bank, find the best interest rate and time horizon that allows your cash to accumulate interest until maturity. CDs are normally FDIC insured by your chartered bank or NCUA by a local credit union. You can also purchase CDs from a broker dealer who has access to institutional offerings of additional nationally chartered banks who are also FDIC insured. This can be a helpful tool for those clients looking for higher amounts of FDIC insurance with multiple bank charters if they are concerned with the $250,000 FDIC insurance limitations.

U.S. Treasury Bills (T-Bills), on the other hand, are offered by Treasury Direct as well as broker dealers. T-Bills range from 30 days to 12 months in their maturities. They are purchased in $1,000 increments at a discount to par or slightly below 100 cents on the dollar. For example, an investor wanting to buy a 12-month T-Bill that pays 4.80% APY may buy 100 T-Bills at $95,420.00 and in 12 months their T-Bill will mature at par (100 cents on the dollar) or $100,000.00 ($100,000/$95,420= 4.7998%).

Now that we got the definitions and how to acquire a risk-free rate of return, let’s get into the why or why now questions.

As indicated in my December Market Update, the U.S. Economy has been drunk on an extremely low interest rate environment for over a decade due to the Federal Reserve’s Zero Interest Rate Policy (ZIRP) since the great financial crisis of 2008 (AKA The GFC). Interest rates have remained relatively low and just started moving up in 2018 and 2019 where most bank money market accounts were paying just of 1% and just when we started to get some lift off in interest rates in comes COVID-19 and rates move down to historic lows. Ten-year treasury rates went down to 0.40% in 2020 and 30-year mortgage rates were in the range of 2.75% to 3%.

Why this is important to understand is because, when interest rates are extremely low, there is a loosening of money supply that encourages small and large corporations to finance their growth with low interest rates, and individuals and families are encouraged to buy and finance real estate at record low interest rates. This loose money supply may also create short-term asset bubbles in speculative assets such as real estate, stocks, and yes, even cryptocurrency. When money is free, the discipline of where to allocate those dollars become waivered. During 2020 individuals, families, and businesses received funds in the form of stimulus checks and payment protection program (PPP). This extreme laxity in money supply combined with historically low interest rates pulled forward consumer demand in goods and services, which has paved the way for the inflation we are seeing today.

The Federal Reserve has one weapon in its arsenal to fight inflation and economic recessions -- the raising and lowering of the Federal Reserve rate (Fed Rate). When inflation runs high, the Fed will raise interest rates to decrease money supply and when economic contraction takes place, which may give way to economic recession, the Fed will lower interest rates to increase the U.S. money supply. Unless you have been living under a rock for the past year, the term “Rate Hike” has been ingrained into most all financial conversations since the end of 2021. When inflation has risen to levels not seen in 40 years, the measures of which the Federal Reserve must implement to reduce inflation may feel borderline violent.

Your investments in the growth stocks of years past may feel like a white knuckle ride into poverty if you have not set the proper asset allocation for your overall risk tolerance. Just as I mentioned in the previous paragraph, the same companies that were financing their growth at extremely low interest rates are now having to finance their growth at interest rates 100% to 150% higher than the low rates of 2020 and 2021. This leads to future corporate growth forecasts being cut for fears of this continued cycle of monetary tightening. Companies that are more established in their business model, who may not need to finance future growth, will fare much better during these economic conditions. These companies are also known a low duration stocks or low beta stocks since the risk of their performance is less impacted by monetary tightening cycles. Cleveland Fed President, Loretta Mester, provided additional commentary on the current Fed policy on taming inflation. She mentions, “I do think we need to be somewhat above 5% and hold there for a time in order to get inflation on the sustainable downward path to 2%.” Based on Mester’s comments, the current monetary tightening cycle will remain in place until the consumer starts to run dry in their cash reserves and/or unemployment increases to levels that weakens consumer demand. This economic slowdown is the recession that everyone has been anticipating since last spring. Even though, the frequency of rate hikes have slowed, a higher for longer rate environment is still a form of monetary tightening and may result in a higher for longer runway for the risk free rate for current investors.  

Over the past decade, investors who are in or near retirement or younger investors, building their savings nest egg, were faced with paltry interest rates at or below 1% annually which, in many instances, forced their hand to step out further into the risk curve and invest in some type of interest paying corporate bond, dividend paying stock, or diversified mutual fund that provided the necessary growth and income that was needed to help sustain their current or future income needs. This term was also called “TINA,” which stood for There Is No Alternative. The choices were “invest or have a guarantee of fractions of a percent.”

Sure, there were principal protected annuity products that guaranteed 2% or 3% annual returns if you were fine to lock up your money for three to five years. Now with the short-term risk-free rate of return over 4.5%, stocks and bonds have a formidable competitor vying for the dollars to be allocated in safe principal protected investments. This new term has been coined “TARA” or There Are Reasonable Alternatives. This has been a very attractive investment option for one of the largest and wealthiest demographics of investors, Boomers. Baby boomers (ages 58 to 79) hold the largest share of U.S. household wealth at this time and many are feeling like they cannot experience another downturn in their stock and bond portfolios as they did last year.

The risk-free rate environment is the highest since pre-GFC (prior to 2008 Great Financial Crisis). The Fed’s stance on their current interest rate policy is higher for longer” based on Jerome Powell’s last FOMC meeting on Feb 1. Based on the recent CPI report in mid-February we saw a bit of a surprise. Due to the tight labor markets and resilient U.S. consumer, inflation still remains sticky in many parts of the economy.

The bad news is for inflation to reduce dramatically to the 2% Fed target, the current monetary tightening cycle will remain in place until the consumer starts to run dry in their cash reserves and/or unemployment increases to levels that reduce consumer demand, which in turn reduces overall prices of goods and services which reduces inflation to the projected target that the Fed is looking for. The Federal Reserve doesn’t need to hike rates like they did in 2022. Keeping interest rates higher for longer is still a form of monetary tightening and may result in a higher for longer runway for the risk-free rate for current investors.

Keep in mind that your purchasing power is still being eroded by a 5.9% inflation when receiving a risk-free rate of return of 4.5% so, having a portion of your investment allocation in stocks can provide a longer term relief from inflation. Equities have been deemed as the best long-term investment tool to outpace inflation when it comes to overall total return and liquidity. When making any investment decision it is important to know your time horizon and risk tolerance when investing in any risk asset so, you can have the fortitude to weather the ups and downs of the economic cycles. Speaking with a licensed financial advisor or Certified Financial Planner may provide further insight and help align your unique goals and future income needs with the appropriate investment strategy to provide the best chance for your future financial success.

Chris Brown Vice President-Investments, Synovus Securities, Inc.