$2.6 Trillion In Money Markets May Slow Interest Rate Increase

by: Robert Wagner

One of the big fears investors have is what will happen to the stock markets when interest rates begin to increase. That is a legitimate fear, but there are factors that may slow and/or lessen the eventual increase in interest rates that may provide a buffer for the stock market. Currently there is approximately $2.6 trillion sitting in mutual fund money markets. To put that number in perspective, the market capitalization of the S&P 500 is approximately $15 trillion, and the GDP of the United States is approximately $15 trillion, and the U.S. debt is approximately $17 trillion.

Most likely, investors will first use their money market holdings to buy stocks before they sell their bonds to buy stocks. From the above linked report, retail money market assets decreased by $1.3 billion over the last week, while institutional money market assets actually increased by $0.26 billion. That may help explain where some of the fuel is coming from that is driving the market higher.

The trends in mutual funds also provides evidence for the above defined theory. While the information is not as current, it does show that assets in taxable bond funds actually increased between the end of the year and the end of March, a period when the markets were up strongly. Money market assets for the same period fell. Another interesting statistic is that total taxable bond fund assets are approximately $2.9 trillion, an amount larger than the assets in money markets. This may present a problem if the fear of increasing interest rates causes investors to rush to lock in their profits, which would create a self-fulfilling prophecy of higher rates and lower bond prices. The cash position however should delay that possibility, but that possibility exists all the same.

Looking at the trend in interest rates also provides support for the theory. Since November 2012, the S&P 500 is up almost 300 points, or over 20%.

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Over that same time period, interest rates have traded in a narrow trading range, and as recent as early May, were trading near the level they were trading at back in November.

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While the Federal Reserve's QE is distorting this market, it doesn't change the fact that the evidence shows that money is flowing from money markets into equities, and so far, it doesn't appear that investors are selling their bond holding to fund their stock purchases.

In conclusion, there appears to be plenty of fuel on the sidelines that can be used to propel the stock market higher. Over $5 trillion in assets sit in mutual fund money markets and taxable bond holdings, which can provide funds to buy equities. I would expect, and the evidence appears to support this conclusion, that investors will first use their money market assets to fund their stock purchases before they sell their bonds. With interest rates at or near record lows, this may be the exact opposite tactic investors should be implementing, but the evidence seems support that is what is happening. I would imagine this is investor inertia, or the "old habits are hard to break" phenomenon. Using money market assets before selling their bond holdings is likely the pattern most investors historically follow, but this time is different, this time we are starting on the floor for interest rates, and the probability of them going higher is almost a certainty ... eventually. Money markets are variable rate instruments and won't lose their value when rates increase, so in this environment, it may be wiser to reverse the historical pattern of using money market first and then bonds, and sell the bond holdings first when values are near a peak, and use the money market after the bond assets have been exhausted.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.