My seven-year-old had an “aha!” moment this week. She wanted to play with her friends, but also needed to finish her chores. I reminded her that if she skipped her chores, she'd forgo her allowance, and then she wouldn't have much for snack sale at school. After a few moments of consideration, she chose to finish her chores. The next morning, when I gave her the allowance, I reminded her she could use it to buy snacks or save it toward her big purchase: a Hatchimal. Again, with thoughtful consideration, she put her money away.
Little did she know, she'd just learned the power of opportunity cost. The opportunity cost of not getting her allowance outweighed the benefit of playing with her friends at that moment, and the opportunity cost of not having enough money to purchase her favorite Hatchimal wasn’t worth having a snack that day.
As investors, we have to make these kinds of tradeoffs every day, often with incomplete and imperfect information. That's how I view higher short-term interest rates right now. They've moved into the 4-5% range (chart below) for the first time in 15+ years, looking oh-so-tempting, like that snack sale at school.
What's the catch? Opportunity cost. While short-term assets can certainly earn us decent yields, we must remember what we're forgoing when we focus on the near wins instead of diversifying between the short and long term. Despite market volatility this year, almost every major asset class has still outperformed these higher short-term yields (chart below). Remember, yields are quoted annually, so a 4% short-term yield over the first two months has only returned ~0.6%.
So what do we do with these higher short-term rates? Do we ignore them altogether? Absolutely not. As with all things investing, we simply have to keep our goals in mind and invest accordingly. Let’s take a look at each individual asset class and field some common questions we’ve been getting about these higher short-term rates.
What should I do with excess cash?
One way to take advantage of higher interest rates is with any excess cash savings you may have. To be clear, this would be your emergency fund or cash for any short-term responsibilities or goals you have coming up in the next six months. This would be one of the easier ways to take advantage of these higher rates without having to overthink it.
For my bond allocation, should I be focusing on the short term?
What kinds of bonds you invest in depends on your goal(s) — and luckily, you have options here. If you need the funds for a down payment in the next year or two, short-term bonds may be a good option. But if your goal is to invest for the long term or generate more income, you may want to diversify and invest across all maturities so you can potentially benefit from locking in these high current rates for a longer period of time and avoiding reinvestment risk. Not to mention average muni bond yields, which are around 3% right now (the taxable equivalent of 4.8%, if you’re in the highest tax bracket).
Also, a note on I-bonds: This type of bond has been in high demand over the past two years, as investors have been understandably concerned about inflation. However, keep in mind that inflation may have peaked last summer, and that I-bonds yields reset every six months. So if inflation continues to wane as hoped, yields on I-bonds will drop, too.
Will stocks continue to fall if interest rates go higher?
The short answer is, as always, it depends. No one can determine stock prices in the short term. US equity markets (the S&P 500) rose 8% this year until February 2, when the jobs report found that 517,000 jobs had been added to the economy.The Federal Reserve is still battling inflation, and a tighter job market may cause services-related inflation to linger, which means it’s possible interest rates will remain high (or get higher) for a while yet. We’re seeing this even now: Post-jobs report, the 10-year treasury yield rose 0.6% from 3.3% to 3.9% and equity markets dropped 5%. Despite that early uptick, the S&P 500 was down 2.6% in February overall.
Regarding the long term, here’s what we know: Valuations for US stocks are currently higher than long-term averages, but are significantly lower than they were two years ago. (Valuations outside the US are below their long-run averages.) Recession risks also look as though they’re abating. We also know that 1) 2022 was a rough year for stocks, 2) stocks typically go up over the long run, and 3) periods of high interest rates have historically coincided with strong stock market returns. And while investing in equities right now may still feel tough, one good way to take advantage of this period would be to ensure your portfolio is properly diversified and use volatility to your advantage by dollar-cost averaging.
Higher interest rates have created many opportunities that we haven’t seen in years. But no matter what, investing will always involve tradeoffs, so understanding the opportunity costs of taking one path versus another should always be considered when you’re working toward your financial goals. Higher-yielding cash investments can, of course, always play a role in a well-diversified portfolio. But they should never be your only focus, no matter how high those rates are. Otherwise, you might find yourself a bit short of getting that prized Hatchimal down the road.