Fed to savers: Cash is trash

BOSTON (MarketWatch) � The Federal Reserve has telegraphed the future of interest rates and inflation, and here�s the takeaway: �Money-market funds are the Stupid Investment of the Week.�

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Stupid Investment of the Week showcases conditions and characteristics that make a security less than ideal for the average consumer, in the hope that spotlighting trouble in one case makes it easier to avoid trouble elsewhere. The column is not an automatic sell signal, which is particularly true for people who use money funds to park cash that they can plow into an investment strategy on a moment�s notice.

But most people don�t use money funds that way, and that�s part of the problem.

Money in the (piggy) bank

Money funds are designed to be ultra-safe cash-equivalents, and traditionally they provided a bit more return than bank certificates of deposit or savings accounts.

But for about 18 months now, nearly two-thirds of all money funds have yielded under 0.01%. To see just how horrible that is, consider that if you had $1,000 and split it evenly between a money fund and a piggy bank, at the end of a year the fund would only be ahead by a nickel.

This is not a new problem, but the Fed paints it in a new light. Central bankers made it clear that savers will not see any boost in money-fund returns for the foreseeable future, and can be sure that inflation will take its full bite out of their cash. So if you use a money fund for emergency savings, the dollars aren�t growing even as the cost of insurance is rising.

Even when rates rise, money-fund yields aren�t likely to go up. Financial-services firms have been waiving costs, basically operating their issues as a loss-leader to keep assets in-house; many smaller firms have simply shuttered their money-market funds. When rates finally do go up � and the Fed forecast doesn�t mean it can�t happen, it just suggests that it won�t until 2014 � firms will first take much of any increase for themselves.

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In short, it will be at least 2015 before money-fund holders get anything approaching a meaningful return.

�The only justification for keeping cash in a money fund is if you want the flexibility to put it back into the market at a moment�s notice,� said Greg McBride, senior financial analyst at BankRate.com.

�Money funds are no place for your emergency fund,� he added. �Park your emergency fund in an online savings account. Yes, the top yields are still below 1% but that is 50 times what you�ll earn in most money funds � and it�s both FDIC insured and completely liquid.�

Climb a risky ladder

Without going up the risk scale towards bonds and bond funds, investors won�t find much return on their cash. Informa Research Services reports the average $10,000 money-market account at a bank as having a yield of 0.21%. Of course, if an investor wants to keep cash in a longer-term parking place until, say, the Fed expects rates to rise, they can get about 1.5% on the three-year certificate of deposit.

Mind you, the fact that money-market returns are so low is not a reason for the average investor to go bolting into the stock market. One thing that is worse than getting no return and losing ground to inflation is losing money in the market.

�There�s no argument that cash is dumb in this environment,� said Peter Crane of Crane Data, which researches money-fund trends. �The question is, �Is what you want to go to instead of cash even dumber?� If what�s important is having your cash ready and at hand, then no return is the cost you pay for convenience. But if you have been keeping your cash in a money fund waiting for rates to get better, they�re not going to for a long time, so maybe it�s time to put some of that other money to work safely.�

The longer the time frame, the more important it is to diversify risks and broaden into more and different securities. Experts have been recommending everything from short-duration bond funds to high-yield corporates to dividend-paying stocks as alternatives to cash. Each comes with its own risks, and the potential for loss is greater than what an investor faces in a bank account or money-market.

Said Crane: �If you�re an income investor, you have to go heavier into bonds and to where the income is, because you have no reason to believe you will get income from your money fund. If you are a cash investor � and you need to keep the money in cash � well you can do better than a money fund in a good bank account, but you�re still going to have to take the beating that the Fed is giving you, and is going to keep giving you for a few more years.�