The US Federal Reserve raised interest rates again on July 27, in a second abrupt escalation one month apart, an additional 75 basis points, or 0.75 percentage points, was added to several prior actions for a total estimated increase of 2.25 percentage points.

Economic strata and US capital markets reacted positively, viewing this Fed effort in tightening monetary policy as a further determined strategic move to control inflation in the US, smooth out commerce, encourage savings, and return the economy to a more stable, less “bubbly” position.

Similarly, most of the rest of the world economies’ central banks along with Bermuda – always looking to the US Federal Reserve for guidance – implemented interest rates increases in varying degrees.

The banking and investing world are impacted in both negative and positive ways by central bank interest rate adjustments, upward and downward.

Debt, credit and fixed-income securities

Negatively affected by higher interest rates are mortgage lending, particularly borrowers with adjustable-rate mortgages, those whose five-year fixed mortgage rates are up for renegotiation, new home purchasers, possible credit card rates, values and yields of current notes and bonds in capital market circulation, commercial or personal credit lines of credit and related debt. More on this impact in future article.

Savings and term deposit accounts

Positively, after years of abysmally low interest income payouts (see chart), there are some real pluses for savings, term deposits, new saving accounts, old flexible accounts, term deposit rollovers, and/or inflation-linked deposits, as savers may see banks increasing interest income rates.

Savings and term deposits are carried in banking customers’ accounts as liabilities on a bank’s balance sheet. Another future story will offer a full explanation of that statement.

The interest payout structure is a pure math calculation, x principal amount times a y interest rate, compounded over a specific time frame. Your term deposit is in cash only, liquid with a possible penalty for early termination, has no underlying securities and is not traded on an open investment market. It may have a dedicated time frame to maturity or can be compounded indefinitely (also known as a savings account).

Money market mutual funds

Money market mutual funds rates are also impacted and reflecting market activity, will react in concert to increased interest rate returns. The interest/dividend payments rate will ramp up the income ladder if central banks’ inflation-control actions continue to push rates upward.

Money market mutual funds can be equated similarly to savings accounts, but they are significantly different, considered cash-equivalent securities, employed 24/7 by millions of institutional and individual investors worldwide.

Understanding a money market mutual fund’s structure

The Reserve Fund, the first money market fund in the United States was created in 1971. Imitators quickly followed. Currently, money market fund assets globally are close to $5 trillion. Locally, MMMFs first became available and popular on a retail level in Bermuda around the start of the new millennium (2000). Interest rates were on the rise at that time, too.

Some older local investors will remember those euphoric days in the early 2000s of money market mutual funds paying up to 7 or 7.5 per cent, all kinds of tech funds displaying gigantic returns then values crashing later, while financial institutions on island opened their doors to new investment centres for their retail customers.

Investing was no longer the purview of those who had portfolio managers and advisers, it was now open to everyone.

Such an exciting time. Investing had become democratic.

Inception structure

Money market mutual funds are bundles of various types of highly liquid, low-risk, high-grade, very short-term debt instruments: commercial paper, banker’s acceptances, repurchase agreements, as well as US Treasuries and agencies, etc.

They are generally issued in various short-term durations from seven days to less than nine months maturity.

Further, the funds in the past always maintained a stable net asset value of $1 per share. This is where, because that par value did not fluctuate, or show a loss during market volatility, the funds appeared similar in perception to term deposits.

Enthusiastic beginner investors often originally assumed that the returns of MMMFS were fixed and guaranteed, just like their understanding of term deposits. They commenced pouring cash from lower interest rate savings / deposit accounts into those MMMF great returns.

Impact of the sub-prime credit crisis

One, par value could not be maintained, as some MMMFs purchased CMOs, CDOs and other debt securities, which, while rated low-risk and high creditworthy were so name only. Funds were in loss positions as the sub-prime market collapsed

Two, unhappy investors liquidated accounts uninhibited by gates, causing numerous funds to close, including the first – The Reserve Fund.

Three, the Fed aggressively lowered interest rates.

Investors then watched as MMMF rates fell, down, down the interest rate ladder in concert with the sub-prime mortgage, global capital markets crash of 2008 as the US Federal Reserve cut interest rates to the bone, flooding US markets with “easy” cash to stimulate economic growth.

The result

The market chaos finally receded, stability returned, but the populace experienced a difficult, long recession.

And as for those money market mutual fund structures, the US SEC put reform regulations in place to manage and protect investors’ understanding of the products.

Reading all this, why would anyone want to invest in a money market mutual fund?

There are very compelling reasons.

Stay tuned next week for part 2.

References

“How a money-market fund works”, https://www.investopedia.com/terms/m/money-marketfund.asp/

Bloomberg Inflation Is Fuelling ‘Most Uncertain Time’ in Investors’ Careers by Alex Harris

• Martha Harris Myron is a native Bermuda islander with US connections and author of Bermuda’s First Financial Literacy Primer – the Dawn of New Beginnings. The Bermy Island Finance Blog will officially launch Sunday August 14 2022. If interested, you can subscribe by e-mailing info@marthamyron.com