Cash management in an evolving rate environment

The potential advantages of holding cash differ depending on the current economic environment. For example, when interest rates are high, holding some cash can make sense. However, when interest rates are falling, converting cash into investments can prove to be a lucrative financial strategy. In high interest rate environments, many investors might be overallocated in cash. However, in lower interest rate environments, yields drop and remaining overallocated in cash could put long-term financial goals at risk. As interest rates evolve, staying attuned to optimal considerations around holding cash versus putting cash to work can be key in defining a long term investment strategy.

Long story short: When the Federal Reserve (Fed) is in a rate-cutting cycle, those evaluating their financial plans may benefit from reassessing their holdings, and investors might want to consider allocating more of their cash holdings out of cash and into investment vehicles. Strategies such as diversifying between short-term instruments like money market funds and longer-duration bonds may provide attractive liquidity and yield. Read on to learn more.

Adapting to a falling rate environment

For companies or consumers, high borrowing costs may mean extra pressure for companies or consumers. For investors, elevated interest rates can offer an attractive risk-free return on cash and cash equivalents. But the flip side of this is that when the Fed or other central banks begin lowering their key policy rates, the environment for cash management can change significantly.

Cash investments may still provide attractive returns in the early stages of a rate-cutting cycle. But if the Fed continues to cut rates at a steady clip, those returns tend to gradually decline and consequently provide less and less incentive to remain invested.

This may lead investors to reevaluate their cash management strategies when the central bank begins cutting rates. With interest rates currently range-bound and future movements being uncertain, investors should consider rebalancing their portfolios to align with their risk tolerance and financial goals. This might involve reallocating cash holdings into equities, real estate or other asset classes that offer potential for higher long-term returns, while still maintaining a sufficient liquidity buffer to navigate potential rate fluctuations.

However, those investments also typically carry more risk. That’s why it’s important to maintain a flexible strategy and consider both returns and market risk amid rate-cut cycles.

Managing duration and inflation risk

As the Fed’s benchmark interest rate declines, bond yields across various maturities may follow suit, which would make reinvesting in cash-like instruments like bonds less appealing across durations. To secure higher returns before yields fall further, investors may consider shifting some of their cash holdings toward longer-duration bonds like 5- or 10-Year Treasuries to lock in more favorable rates in the early stages of a cutting cycle.

For investors who do so, it’s essential to remain vigilant about the duration risk of those securities. Unlike cash or short-duration securities, longer-duration securities are highly sensitive to interest rates. The fixed interest rate locked in when buying the asset won’t change, but five or 10 years leaves plenty of time for rates to fluctuate, which may reduce the investment’s mark-to-market value before maturity.

Investors should remain vigilant about inflation risks, especially given current fiscal policies that could impact inflationary pressures. In this uncertain rate environment, incorporating inflation-protected securities, such as Treasury Inflation-Protected Securities (TIPS), into a diversified strategy can help preserve capital and enhance resilience against potential inflation.

Productivity may pay off

There’s no way to know for sure whether the Fed will continue cutting rates or how fast it plans to do so. And cash may well offer attractive returns regardless in the early stages of a rate cut cycle. Nevertheless, investors may be wise to proactively explore opportunities to manage cash more effectively and ensure they are well-positioned to adapt their holdings to the current interest rate environment.

Advisors can play a crucial role in guiding clients through this period by assessing their cash needs, risk tolerance and time horizon. Speak to a JPMorgan advisor today to get help getting started.

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