A few weeks ago, I detailed how I was moving most of savings into Treasury Bills. The last couple weeks a have been an excellent lesson on the risks and potential benefits of a more active cash management strategy. But before I get into what’s happened with my monies, I want give a very simple overview of interest rates and how the interest rates for different savings instruments such as money market fund, CDs, etc are affected by what’s happening in the debt market.

Any fixed income type of investment such as a CD or Bond or even savings and money market account are tied to the debt markets. The debt market is where the government and corporations go to borrow. Bond investments are directly tied to these markets as bonds prices are set by what people are willing to buy and sell these obligations at. The lower the price, the higher the effective interest rate. For example if a bond that sells for $1000 pays $100 annually in interest, it’s basically paying 10% interest. Let’s say for whatever reason people are only willing to buy that bond now for $800. The effective interest is now 100/800 or 12.5%. While we might not think of CD investments, savings accounts, and money markets as part of this market - they are. Banks invest in bonds and other debt obligations, take a cut from the top, and pay interest to our deposit accounts.

So what affects the interest rate on any particular piece of debt? The overall economy, and credit risk. Borrowers who are more likely to default pay higher rates to offset the higher chance of default. The other piece, the economy, is more complicated. One piece is the expectation on inflation. If inflation is higher interest rates need to be higher not only get over the inflation hurdle but people expect the Federal Reserve will raise interest rates to combat inflation. For the same reason when economy is stagnant the market will anticipate lower interest rates from the Fed even before the Fed lowers them. The Fed can effectively set short term interest rates by fiat, and most of the time longer term rates will follow. Of course in truth, it’s all much more complicated, and entire books can be devoted to the subject.

So what happened to my treasury investments? I actually got pretty lucky. As you can see on the graph above the interest rate for the 4 week treasury T-Bill peaked on August 2nd. As an individual investor when I participate in the treasury auction, I have no say in what price I buy, and receive whatever rate the auction clears at. Luckily, I decided to buy on August 2nd and August 9th, the recent peak. The credit market preceded to melt down later in the month. The spread between good borrowers and bad borrowers increased dramatically. It became much harder to borrow money. The Fed responded to problem by 1) injecting more money into the system by buying illiquid debt backed by subprime mortgages 2) subsequently lowering the discount rate from 6.25% to 5.75% (this is the rate that Fed lends money to banks overnight). The actions by the Fed, and fear in the market has effectively lowered the interest rate that secure instruments such as 4 week t-bills pay.

While I was lucky in my timing, one of the risks in investing in T-Bills is that the interest rate on them can move quickly. I could’ve easily thought I would be getting 5% and only end up 4.5%. The interest rates in deposits at the ING and HSBC tend to be a little more stable given that they track the Fed Fund rate (another interest rate that the Fed sets) which changes but is less subject to short term fluctuations. One way to avoid short term volatility is investing in longer term treasury bills such as 26 week bills, but then money is locked up for a longer time. Also another way to take advantage of sudden movements is to lock in CD rates. The day the Fed lowered the discount rate, I locked in a 12 month CD at ING at 5.35%. Given that rates offered CDs will track prevailing interest rates, ING has since lowered the rate offered to 5.15% as would be expected.