Safe and Boring Are Starting to Look Beautiful

The revenge of the boring, low-risk cash account may be upon us.

When Federal Reserve policymakers meet on Tuesday, they are virtually certain to raise their benchmark short-term interest rate a quarter of a point, to 4%. It would be the 12th such increase since mid-2004.

That move should assure that rates on bank certificates of deposit and money market accounts will continue to rise as well.

Certainly, nobody’s in danger of getting rich off single-digit bank yields. Still, this is the best that savers have had it in four years. And given the relatively poor returns on U.S. stocks and bonds this year, people who prefer to play it safe may be feeling a bit smug.

Despite a rousing stock rally Friday after the government’s surprisingly strong report on third-quarter economic growth, the blue-chip Standard & Poor’s 500 index is barely positive this year, up about 0.3% including dividends. The average U.S. stock mutual fund is up 1.3%, according to Morningstar Inc.

Long-term U.S. bond mutual funds are up 1% to 2% for the year, on average, including interest earnings and principal change.

Compared with those results, the 3.2% annualized yield on the average money market mutual fund sounds enticing. The 4.2% yield on six-month Treasury bills seems downright lush.

In the 1990s, investors were taught that cash was trash. Stocks were the place to be, and bonds were a fine idea too.

In this decade, the preferred investment has been real estate.

But as long as the Fed is tightening credit, stocks, bonds and real property all face a troubled outlook. The one beneficiary of the central bank’s rate-raising campaign is cash.

Now, no respectable financial advisor would suggest that clients take this year’s investment results as a reason to shift every last dollar into a money market fund or a T-bill.

Some make the case that this is a great time to be bargain hunting for stocks. Others say we’re getting close to the point where investors will want to lock in long-term bond yields.

Even so, if the market trends this year have given investors a better appreciation of cash’s role as a stabilizing force in a portfolio, that wouldn’t be a bad thing.

Nor would it be so bad if people viewed rising short-term interest rates as an invitation to boost, or create, the emergency savings fund that every family should have (think hurricanes, earthquakes, sudden illness, etc.) but often defers because of spending needs or wants.

A cash account is the right place for emergency funds. Unlike with stocks, bonds and real estate, it’s hard to lose principal when you’re saving in a short-term account. Bank accounts are federally insured, Treasury bills are direct obligations of Uncle Sam, and money market mutual funds are nearly bulletproof as well.

There is evidence that Americans are getting the saving bug again: The total in bank savings certificates of $100,000 or less has jumped to $949 billion from $817 billion at the start of the year, according to data from the Federal Reserve Bank of St. Louis.

Fed policymakers must be happy to see this. They have warned about the potential perils of the nation’s spendthrift ways. Consumer spending continued to be robust in the third quarter, the government’s report Friday showed. But that was at the expense of saving: The official national savings rate was negative in the quarter, which meant that people spent more than they earned.

Americans didn’t have much incentive to save in 2002 and 2003, when the Fed kept short-term interest rates at rock bottom. As the payoff improves, the excuse that “saving isn’t worth it� loses legitimacy.

The big question, of course, is how much higher cash yields may rise from here.

Assuming the Fed lifts its benchmark rate to 4% on Tuesday, it would reach the lower level of the range in which most economists figure policymakers will stop -- somewhere between 4% and 5%. Within that range, it’s believed, is the “neutral� rate: the point at which interest rates neither stimulate the economy nor hurt it, and at which inflation pressures will be sufficiently damped.

But the retirement of Fed Chairman Alan Greenspan on Jan. 31 complicates the outlook.

President Bush last week nominated Ben S. Bernanke, chairman of the White House’s Council of Economic Advisors, to succeed Greenspan.

What constitutes a neutral rate in Greenspan’s mind might not in Bernanke’s. So wherever the Fed’s rate is by the time Greenspan leaves (he will chair two more meetings after this week’s, on Dec. 13 and Jan. 31), it’s possible that the Fed under Bernanke could keep raising rates in 2006, could leave them unchanged or could begin cutting them.

The decision obviously won’t be made in a vacuum. It will probably depend largely on the strength of the economy and whether inflation pressures from high energy costs filter into prices of other goods and services over the next few months.

The government’s estimate Friday that gross domestic product grew at a real annualized rate of 3.8% in the third quarter was good news for the economy. But it also gives the Fed the cover it needs to continue raising interest rates, many analysts figure.

That’s apparently how bond investors viewed the GDP report. The yield on the 10-year Treasury note, a benchmark for other long-term interest rates including mortgage rates, ended at 4.57% on Friday, up from 4.55% Thursday and just under the seven-month high reached on Wednesday.

The jump in long-term rates over the last two months has reflected worries about inflation (which eats away at fixed-rate bond returns) as well as expectations that the Fed would keep pushing up short-term rates.

The stock market, too, is jittery about inflation, but it’s probably more concerned about the competition for investors’ capital that rising interest rates present.

Although the Dow Jones industrial average surged 172.82 points to 10,402.77 on Friday after the GDP report, it has been mostly stuck between 10,200 and 10,400 since Oct. 4. And it’s down 3.5% year to date, not counting dividends.

If the Fed gives any signal at all that it might be nearing the end of its credit-tightening drive, the news could fuel a big rally on Wall Street. It also might spark a rush into long-term bonds, because investors would want to lock in yields if they thought they were cresting.

But the Greenspan Fed can’t speak for the Bernanke Fed (assuming Bernanke is confirmed by the Senate), so the likelihood of such a signal between now and year’s end doesn’t seem very high.

In the interim, then, the rewards for cash savers may continue to grow.

Still, given the possibility that the Fed is nearly done, a “laddering� technique with cash makes sense: splitting savings among, say, a money market fund, a six-month CD and a one-year CD.

Or, better yet, ladder with Treasury bills, which pay more than the average CD and are exempt from state income tax. (You can buy T-bills directly from Uncle Sam at www.publicdebt.treas.gov.)

Here’s one more reason to think about whether you have enough cash in your portfolio: As the Fed tightens credit, the risk grows that it might go too far. Instead of the proverbial soft landing for the economy, it’s possible that the central bank could cause a recession in 2006.

That would be a recipe for a sinking stock market and a weak housing market. Cash, by contrast, would be a nice hiding place. (So would high-quality bonds at that point.)

Another risk to the economic outlook is that consumers may be reaching the end of their spending spree.

Betting against Americans’ desire to spend money has been foolhardy for most of the last 25 years, but some economists say there are good reasons to believe that many consumers are ready to tighten their purse strings. One issue is the potential disappearance of the “wealth effect.�

In the 1990s consumer spending was supported by the booming stock market. Real or assumed capital gains made many people feel richer, which made them feel freer to spend. That’s the so-called wealth effect of rising asset values.

When the bull market ended in 2000, the housing market took off, providing a similar -- and more widespread -- capital-gains wealth effect.

If housing is peaking, however, and if the stock market remains stuck in neutral at best, the wealth effect may be history.

“Above-normal capital gains have supported consumer spending for 25 years,� said James E. Glassman, economist at JPMorgan Securities in New York. He thinks it’s inevitable that spending will slow soon without the wealth effect as a prop.

“I think people are seeing it’s a new environment that is unfolding,� he said.

Joseph Carson, economist at Alliance Capital Management in New York, also figures the housing boom is at an end, and with it the heady consumer spending it supported.

“We’ve been living beyond our means,� Carson said of consumers’ outlays in the last few years.

Of course, it would be naive to think we would turn into a nation of savers overnight.

And if energy prices fall in the next few months, many consumers might regard that as a green light to head for the mall again.

What’s more, if the economy stays on track and the unemployment rate remains low, income growth should continue to support a decent rate of spending growth, said Mickey Levy, chief economist at Bank of America in New York.

The Fed doesn’t want spending to collapse. But in continuing to raise short-term interest rates, it’s also offering a reward, of sorts, to consumers who want to repair their own balance sheets by raising their saving levels in no- or low-risk accounts.

Tom Petruno can be reached at [email protected].