Short-term cash is back in style with yields sizzling around 5%, but watch out for a Fed policy U-turn, says investment strategist

• "Boring" money markets funds are in style with short-term bond yields up, said SoFi's Liz Young.
• Yields are in the 5% range as investors see the Fed potentially driving up its key rate higher.
• Young said if the Fed were to swing back to rate cuts, watch out for falling yields.

A year after the Federal Reserve embarked on its most aggressive run of rate hikes in decades, once-staid investments are fashionable again, albeit with some risks.

The short end of the US Treasury yield curve in particular is turning heads as investors are preparing for the Fed to keep jacking up its benchmark interest rate as inflation looks sticky.

Now, "boring money market funds and short-term 'cash' instruments are back in style," with a recent surge in flows for maturities of less than one year notable, Liz Young, head of investment strategy at personal finance platform SoFi, wrote in a blog post this week.

In fact, there's a record $4.8 trillion of cash being held in money market accounts overall, with retail investors alone adding $9.9 billion in late February.

"The good news is investors can get the highest yield since 2007 on 3-month Treasury Bills," Young said. The 3-month Treasury yield is 4.9%. Meanwhile, yields on the 6-month bill and the 1-year bill have reached 5%.

"The bad news is this inversion is the deepest it's been since the early 80s."

Curve inversion

The inversion refers to short-term yields rising above long-term yields, and such flips warn of a recession. The signal has been flashing since last year, and it contributed to the bear market in stocks in 2022.

She said an even more specific inversion to watch is between 3-month and 10-year Treasurys. The 10-year Treasury yield was at 3.9% on Friday.

A former market strategy director at BNY Mellon Investment Management, Young said inversions on this measure have preceded recessions every time but once since 1962.

"And even when an inversion occurred in 1966 without a recession to immediately follow, it was during a time when inflation was a problem that didn't get solved, only to rear its ugly head and cause a deep recession a few years later," she noted.

Investors have been worried that the Fed's aggressive pace of rate hikes will eventually tip the economy into a recession, although the strong labor market may be offsetting such concerns for now.

The Federal Open Market Committee is widely expected to deliver its ninth straight rate increase at its March 21-22 meeting. The odds still favor a hike of 25 basis points. But hotter-than-expected inflation readings for January — and some Fed openness to a half-point rate increase — invigorated chances of 50-basis-points move.

But if the Fed were to change course later and start cutting rates, short-term yields would fall quickly, said Young.

"With inflation at these levels, the only reason the Fed would pivot before inflation nears its target is because economic data worsens and worries them. The yield curve would flatten or un-invert, but only because things got worse, not better," she said.

A worsening environment would likely be followed by a drag in corporate earnings and pressure on stock prices.

"That produces the trifecta of recession: market drawdown + earnings contraction + economic pain," she said.