When the Fed cuts interest rates, the era of ‘eyes-closed’ investing with 5% profit will end

Investing in cash is becoming increasingly complex.

Certificates of Deposit (CDs), money market funds, and other equivalent cash investments have proven to be lucrative. Since the Federal Reserve (Fed) began raising interest rates two years ago, many cases have seen rates above 5%.

But after the most recent meeting on March 19-20, the central bank signaled that it expects to cut interest rates three times this year. While some cash-equivalent investments remain stable, others are starting to see a decrease in profitability.

Changes are happening with CDs. According to data from Bankrate tracking the highest interest rates offered by financial institutions, getting a 5% interest rate on a 12-month term last year was easy. Currently, only short-term CDs have high interest rates, such as 3-month CDs with a rate of up to 5.5%. Meanwhile, 2-year CDs have rates below 5%, a decrease from the 5.5% at the end of last year.

Adam Stockton, CEO of consulting and data company Curinos, said that around 70% of high-interest CDs opened in February last less than a year.

“People mostly look at interest rates first, and then the term,” he said. “But the term is actually more important, especially if the central bank cuts interest rates later this year.”

Highest interest rates on certificates of deposit, sorted by term: red – 3 months, green – 1 year, light blue – 6 months, purple – 2 years

Since the Fed started increasing interest rates in early 2022, Americans have been more cautious about where they keep their cash. At that time, stocks and bonds took a sharp downturn. Cash products began offering higher interest rates after years of almost no returns.

When regional banks in the US collapsed in 2023, money flowed into money market funds. Currently, the amount of money in these funds has reached a record $6.5 trillion. According to Crane Data, the average interest rate of these funds peaked at 5.2% in December and is currently at 5.14%.

The Fed may still decide to postpone interest rate cuts. Although central banks have planned for 3 rate cuts, they may change course if inflation remains high. Inflation in February was slightly higher than expected.

According to Curinos, 60% of the CDs purchased in February by consumers have interest rates above 5%, with almost all exceeding 4.5%. This indicates that interest rates remain high.

In addition to changing strategies with cash, investors are also putting their money into other areas. In particular, the stock market has attracted many participants. The S&P 500 index has increased by about 30% in the past year.

Financial advisor Ashlea Jones of Prime Capital Investment Advisors said that some of her clients recently returned to the stock market after their CDs matured.

Dafina Smith, a 45-year-old business owner in Connecticut, purchased a 3-month CD last year with an interest rate of 3.75%, then a 10-month CD with a rate of 5.2%. After that, she invested in a 6-month silver bond.

But in February this year, Smith changed her strategy. She gradually started reinvesting the money from her maturing cash products back into the stock market.

According to financial advisors, when the Fed cuts interest rates, savings rates may be the first to decrease because they change monthly. Next are silver bonds and certificates of deposit.

This leads investors to consider new alternatives.

For example, if interest rates decrease this year, someone who buys a 1-year CD today at 5% could receive more interest than someone who buys with a higher rate but only for a 6-month term.

Retirees or those planning to buy a house in the future may find value in a 2-year CD with a 4.5% interest rate. Heather Welsh, a senior executive vice president of asset planning at Sequoia Financial, said it remains a controllable source of income from money they don’t need immediately.

According to WSJ