Why the surge in money market fund assets? A nonlinear economic perspective

The massive accumulation of assets in money market funds (MMFs) reaching multi-trillion-dollar heights is often framed as a simple reaction to elevated interest rates, but the underlying mechanics reflect a deeper structural shift. When central banks aggressively hiked rates to combat inflation, traditional commercial banks proved remarkably sluggish in passing those gains on to standard checking and savings depositors, keeping yields near zero. In contrast, by investing efficiently in ultra-short-term government obligations, repurchase agreements, and commercial paper, MMFs translated federal funds rate hikes into attractive, realized yields. This stark yield differential triggered a massive, non-linear reallocation of liquidity, as both retail and corporate depositors actively migrated capital away from legacy banking institutions to capture risk-free short-term returns.

Beyond yield chasing, this historic migration has been heavily fueled by a systemic flight to safety and liquidity following recent bouts of regional banking turbulence. Institutional treasury departments and risk-averse investors increasingly balk at holding uninsured cash deposits above FDIC limits in single-institution commercial banks, viewing government-backed MMFs as an attractive alternative in terms of credit quality and daily operational fluidity. Coupled with this behavioral caution is the long-term demographic trend of aging populations, notably Baby Boomers transitioning through retirement. They naturally would tend to de-risk their asset allocations, moving away from volatile equities into capital-preservation vehicles. As broad nominal money supply (M2) expanded through prior fiscal and monetary cycles, these structural forces converged to push total MMF assets into uncharted territory.

A prevailing market narrative assumes that these trillions sitting on the sidelines will inevitably flood back into risky assets like stocks and corporate bonds the moment the Federal Reserve initiates a rate-cutting cycle. However, historical data and economic inertia suggest a more complex reality. A substantial portion of these MMF balances belongs to institutional entities and retirees whose primary objective is operational liquidity or capital preservation rather than tactical market timing. When central banks eventually ease monetary policy, MMF yields will decline, but cash outflows may not precipitate a dramatic rush into equities. Instead, economic slowdowns often prompt risk-averse holders to entrench themselves further in cash equivalents. Financial system liquidity dynamics rarely follow a straight line.

The looming trap for American banks: Why financial stability demands Fed intervention

The American banking sector currently faces an unprecedented level of interest rate risk that threatens the fundamental solvency of traditional lending models. After a decade of suppressed volatility, the rapid transition to a higher-rate environment has left many institutions holding vast portfolios of low-yield, long-duration assets—primarily Treasuries and mortgage-backed securities—that have suffered significant mark-to-market losses. Unlike the liquidity crises of the past, the current systemic fragility is rooted in a duration mismatch where the cost of liabilities (deposits) has adjusted upward far more rapidly than the yield on legacy assets, compressing net interest margins and eroding capital buffers across the industry.

This precarious position is the direct result of a unique "perfect storm" in the debt markets: a prolonged era of ZIRP (Zero Interest Rate Policy) overlapping with an un-inverted yield curve. During the low-rate years, banks were incentivized to "reach for yield" by extending duration. The curve then inverted, and now, as the yield curve moves toward a more "normal" upward slope—not through a drop in short-term rates, but through a "bear steepener" where long-term yields rise—the market value of those long-term holdings is cratering. This transition from an inverted curve to a positive slope is historically where the most acute financial accidents occur, as the "hidden" duration risk in bank portfolios is suddenly forced into the light by market pricing.

Consequently, the Federal Reserve is approaching a pivot point where its dual mandate of price stability and maximum employment may be eclipsed by its implicit third mandate: financial stability. To prevent a systemic de-leveraging event or a wave of technical insolvencies, the Fed will likely be forced to initiate a targeted form of Quantitative Easing (QE) specifically at the long end of the curve. By becoming the "buyer of last resort" for long-dated paper, the Fed can cap long-term yields, effectively engineering a ceiling on duration losses for the banking system. While this may complicate the inflation fight, the alternative—a disorderly collapse of bank balance sheets—is a risk the central bank cannot afford to take.

The hidden power of capital gains in US Treasury investments

For many investors, U.S. Treasuries are synonymous with safety and fixed income, providing a stable stream of coupon payments. However, a less-appreciated source of return is the capital gain realized through principal appreciation. This occurs because bond prices move inversely to interest rates. When the prevailing market interest rates fall, the value of existing bonds with higher, fixed coupon rates rises in the secondary market. If a bond is purchased at par and subsequently sold at a premium due to a drop in yields, the investor captures a capital gain in addition to the accrued interest. This mechanism transforms Treasuries from simple income generators into instruments with significant price volatility and appreciation potential when the market anticipates, or begins to realize, a decline in borrowing costs (see Figure 1).

The scale of this principal appreciation is not uniform across all maturities; rather, it is directly tied to the bond’s duration, which is closely correlated with its time to maturity. Simply put, for an identical percentage point decrease in interest rates, a bond with a longer maturity will experience a disproportionately larger increase in price than a short-term note. This principle stems from the mathematics of present value. Longer-dated bonds possess cash flows (coupons and principal repayment) that are discounted over a longer period. As the discount rate (the prevailing interest rate) decreases, the present value of those distant cash flows increases dramatically. This sensitivity makes longer-maturity Treasuries the most potent way to capitalize on falling rates, embodying the core risk/reward trade-off known as interest rate risk.

Understanding this duration-based leverage is critical for tactical investors. In environments where the Federal Reserve or global economic forces are signaling a shift toward monetary easing, taking a substantial position in long-term Treasuries—such as the 20- or 30-year bonds—can unlock significant capital gains. (This can be done indirectly by investing in funds such as the VGLT.) If a bond with a 20-year duration, for instance, sees its yield fall by just 100 basis points (1.00%), its principal value will appreciate by roughly 20%. This leverage allows investors to achieve equity-like returns from a sovereign debt instrument during periods of yield decline. Therefore, an informed strategy recognizes that long-term Treasuries are not merely hold-to-maturity assets, but powerful tools for capital appreciation in anticipation of a rate-cutting cycle.

Is there a relationship between interest rates and PE ratios?

Summary

- We look at the relationship between 10y Treasury yields () and Shiller PE10 ratios () from 1971 to 2021.

- When these two measures are compared and correlated, without time lags, there seems to be no relationship.

- When we consider time lags, a relationship becomes apparent: periods of tightening, when yields go up, seem to be followed by contractions in Shiller PE10 ratios.

10y Treasury yields vs. Shiller PE10 ratios from 1971 to 2021

The graph below shows the relationship between 10y Treasury yields and Shiller PE10 ratios during the period going from 1971 to 2021. The low Shiller PE10 ratios shown at the bottom generally occur during market crashes. The R-squared for the relationship is shown next to the best-fitting inverted J curve.

As we can see, the 10y Treasury yield explains only 5.1 percent of the variance in the Shiller PE10 ratio, even after nonlinear function transformation (aka “warping”). The relationship is weaker if it is modeled as a linear association. This goes against the idea that there is a relationship between 10y Treasury yields and Shiller PE10 ratios.

Arguably the time period considered is too large to be representative of what might happen today. Notably, the S&P 500 has been much more strongly influenced by high growth companies since 2003, after the crash of the “tech bubble” and the emergence of a few large and very successful technology companies.

10y Treasury yields vs. Shiller PE10 ratios from 2003 to 2021

The graph below shows the relationship between 10y Treasury yields and Shiller PE10 ratios during the more recent period going from 2003 to 2021. Again, the low Shiller PE10 ratios at the bottom occur during the market crash of 2008 (those ratios did not drop as much during the COVID crash), and the R-squared for the relationship is shown next to the best-fitting J curve.

As we can see, the 10y Treasury yield explains 12.3 percent of the variance in the Shiller PE10 ratio, with nonlinear function transformation (aka “warping”). Still, this is a small number, which goes somewhat against the idea that there is a relationship between 10y Treasury yields and Shiller PE10 ratios.

However, closer inspection of the data suggests that market corrections and crashes, where typically Shiller PE10 ratios contract quickly, follow periods of tightening (top-right part of the graph). Also, PE10 expansion appears to occur after easing (top-left part of the graph).

Time series of 10y Treasury yields vs. Shiller PE10 ratios from 2003 to 2021

The graph below shows a time series with 10y Treasury yields in blue and Shiller PE10 ratios in orange, during the period going from 2003 to 2021. Since this is a time series graph, with time varying along the x axis, we can more easily spot lagged relationships.

Here we can see that periods of tightening (blue arrows up) appear to be followed by periods where the Shiller PE10 ratios drop (orange arrows down). This suggests that there is a relationship between 10y Treasury yields and Shiller PE10 ratios.

Conclusion

There seems to be a relationship between 10y Treasury yields and Shiller PE10 ratios. Periods of tightening, when yields go up, seem to be followed by drops in the Shiller PE10 ratios drop. And, given that yields rising precede PE10 ratios dropping, there is a predictive “flavor” to the relationship.

The problem is that as yields go up, so do PE10 ratios, until a point is reached where PE10 ratios drop precipitously. While it is not clear when the tipping point is reached, it seems to occur after a 1 to 2 percent point rise in yields.

Interest rates and PE ratio expansion: S&P 500 going above 4100 before the end of 2020?

Summary

- Most professional investors see price/earnings (PE) ratios as inversely proportional to interest rates.

- Mathematically, this would be expressed as: PE = k / IR.

- Assuming that the interest rate on 10-year Treasuries could rise to 1%, and the k multiplier to rise to the pre-COVID level of 0.39, the expected S&P 500 PE ratio would then be 38.66.

- This would bring the S&P 500 up to 4,148. Still, not as expensive, in PE ratio terms, as in either the 2000s dot-com bubble or the Great Recession.

Interest rates and PE ratios

Most professional investors, including the late Benjamin Graham (), see PE ratios as inversely proportional to interest rates for Treasuries. Mathematically, this would be expressed as follows, where PE = the PE ratio of an equity security, IR = a relevant interest rate, and k = a multiplier.

PE = k / IR

There are a couple of key reasons for this relationship. One is that Treasuries become less attractive as an investment when interest rates go down. Since the Treasuries market is very large, a little over $21 trillion at the time of this writing, even a fraction of it moving to equities would push their PE ratios up significant.

Another key reason for the relationship above is that investing in Treasuries when interest rates are low becomes risky in terms of principal preservation. Treasury prices are inversely related to the interest they pay, or their yields. When yields are very low, the tendency is for them to go up.

Interest rates on 10-year Treasuries

The figure below shows the interest rates for the 10-year Treasury notes from January 2007 to July 2020. Those rates, which influence a number of other consumer-relevant rates (e.g., those for mortgages), go from 4.76% to 0.55% during the period.

While the interest rates have been going down over the years, they went up significantly during the recovery from the Great Recession. The same may happen during the recovery from the COVID recession. A move from 0.55% to 1% would be significant.

S&P 500 PE ratios

The figure below shows the PE ratios for the S&P 500 from January 2007 to July 2020. Note that the PE ratio for July 2020 is nowhere near the peak during the Great Recession.

The k multipliers

Finally, the figure below shows the k multipliers for the relationship between the S&P 500 PE ratios and interest rates on 10-year Treasuries from January 2007 to July 2020. An all-time low was reached for the multiplier in July 2020.

In a low interest rate environment, a high k multiplier would typically be associated with a high PE ratio. The multiplier increase, if it happens, should lag the interest rate reduction. Investors need time to be convinced that interest rates will remain subdued. 

S&P 500 above 4,100 soon?

Assuming that the interest rate on 10-year Treasuries could rise to 1%, and the k multiplier to rise to the pre-COVID level of 0.39 (which is below its historical average), the expected S&P 500 PE ratio would then be 38.66. This would bring the S&P 500 up to 4,148. Still, not as expensive, in PE ratio terms, as in either the 2000s dot-com bubble or the Great Recession.

This PE ratio expansion for the S&P 500 is already happening at the time of this writing, with the S&P 500 hitting an all-time high. Our main point in this post is that, if interest rates on Treasuries remain low, we may see more of that - even with bankruptcies among small businesses, significant  unemployment, and high volatility (including downward corrections).