Key Takeaways

· The Fed interest rate hikes could affect mortgages, car loans, and business borrowing costs.

· Cash management funds could potentially benefit from rising interest rates because they could reflect short-term interest rates, have the potential to generate higher returns, and their popularity is likely to grow among investors.

The Fed's actions to raise rates always make headlines and could have impact on the stock market. At such times, cash management funds can be one of the options to diversify your cash as they provide a relatively higher return amid higher interest rates. According to Crane Data, which tracks cash management funds, yields on cash management funds rose during the rate hike campaign (Dec.31,2021-Jun.30,2022).

Why is that the case, you wonder? Let's first look at what the Fed's interest rate hike is.

Understanding the Fed's interest rate hike

According to the Fed Reserve Board, one of the primary goals of the Federal Reserve, the central bank of the United States, is to achieve price stability. So the Fed will move to control inflation when it seems to get out of control, mainly by influencing the federal funds rate.

The federal funds rate refers to the interest rate at which banks lend their excess funds to each other overnight. Fed influences the rate by buying and selling US treasuries to adjust liquidity. The more liquidity, the lower the fed rate, vice versa. The federal funds rate, in turn, affects other interest rates.

The Federal Open Market Committee (FOMC) has eight regularly scheduled meetings each year. One of its top priorities is to set the target range for the federal funds rate.

After the Fed announces a rate hike, the cost on corporate loans rises correspondingly, which affects business operations, earnings, and even stock prices. Though interest rates on savings account increase, personal debt also becomes more expensive, denting consumer confidence.

Three reasons why cash management funds may benefit from rate hike

1. Cash management funds could reflect short-term interest rates.
According to Feds notes, cash management funds' rates are heavily influenced by the changes in Federal Funds Rates. As short-term rates rise with the expectations of a rate hike, cash management funds that invest in highly liquid, short-term instruments can reinvest their maturing assets at higher yields and generate more returns.

2. Cash management funds may have higher returns thanks to reverse repurchase agreements.
To remove liquidity from the financial system, the Fed may carry out reverse repurchase agreements (reserve repo), i.e., selling a security to an eligible counterparty with a promise to buy it back at a specified price at a predetermined date, according to SEC files and Feds notes. Some cash management funds can park excess cash at the Fed overnight and earn potential interest, as Bloomberg reported.

3. Cash management funds are a safer option compared to stocks during a rising interest environment.  
According to the BBC and Fidelity, as the Fed raises interest rates, investors suffer from higher borrowing costs and grow more concerned about unemployment due to a potential recession; the stock market has also been struggling when rising interest rates have increased the yield on short-term investments, making cash management funds with relatively lower risk and higher liquidity, a place to consider for investors holding cash.