The money market is made up of many multimillion-dollar short-term borrowings by the government and large corporations. These loans trade on the money market in the form of U.S. Treasury bills, commercial paper, bankers' acceptances and bank certificates of deposit. You become an investor in these securities through money market mutual funds, or you can purchase Treasury bills and bank CDs in retail amounts of generally less than $100,000.
What Affects Money Market Interest Rates
The primary influence on money market interest rates is Federal Reserve monetary policy. When the Fed wants to lift the economy out of recession, it lowers short-term borrowing rates by cutting the discount rate and injecting money into the system by buying government securities on the open market. When the Fed wants to discourage inflation, it raises interest rates to discourage borrowing and removes money from the system by selling government securities on the open market. Fed interest rate changes are reflected in the rates on commercial paper, bankers' acceptances and both retail and institutional-size Treasury bills and CDs. When the Fed lowers and raises rates, your money market mutual fund rates fall and rise, too.
Strategies for Rising Rate Periods
When interest rates are rising, the usual strategy is to keep your maturities short -- those maturing in 30 to 90 days. This allows you to reinvest your money at higher rates when your T-bills and CDs mature. Bankers' acceptances and commercial paper generally aren't available in amounts the average investor can buy and are mostly bought by large institutions. Another strategy is to ladder your investments. Buy 30-day, 60-day and 90-day maturities; as each matures, reinvest the money in a 90-day maturity. This way you have monthly money maturing for reinvestment at higher interest rates. Laddering can be done to maximize your return by spreading your laddered maturities out to six months or one year in equal amounts to take advantage of higher yields available in the longer maturities. As rates rise, the dollar value of your investments falls. Money market mutual funds are managed to ladder the maturities inside the portfolio so their returns tend to follow interest rates.
Strategies for Falling Rate Periods
When the Fed announces plans to lower interest rates, the primary strategy is to buy the longest maturities. This locks you into the highest interest rates available at the time. If you have laddered your investments, reinvest your maturities in one-year or longer maturities. This is also a standard strategy of money market mutual fund managers. Bank CDs normally pay higher interest than T-bills, and you can more easily buy them to match the maturity dates you want. Some banks also offer laddered CD packages when interest rates are low. When interest rates start to rise, banks want to keep their cost of funds low, so they offer attractive long rates to lock in inexpensive money for longer periods before market interest rates hit their peaks. Then, when rates start to decline, they offer attractive short-end rates to attract money that will be rolled over at even lower rates.
Treasury Bill Futures
You can play the fluctuation of interest rates through trading T-bill futures, but this can be risky and it doesn't pay interest while your money is in the futures contract. A contract obligates the holder to buy or deliver $1 million face value of the 13-week T-bill at a specified future date. Unless you have a spare million hanging around, you must remember to sell your contract before that date. Because the market for futures moves with interest rates and demand, there isn't a precise correlation between the physical T-bill rates and the futures price, so it is possible to lose money even if you have correctly predicted interest rate movements.
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