Why cash is golden right now

By Tim Middleton

Despite the Federal Reserve's massive efforts to push down short-term interest rates, it's not working -- and that's a boon for savers and investors.

Though the Fed has cut rates a full percentage point since September, to 4.25%, "yields on the top-paying bank savings accounts and money market deposit accounts have declined only fractionally and still remain above the 5% mark," notes Greg McBride, a senior financial analyst at Bankrate.com.

The stubborn refusal of market interest rates to follow the Fed down means cash is not merely king -- it's Midas. Money market funds have delivered rock-steady returns this year at nearly the same rate as stocks, with none of Wall Street's high anxiety.

And a pair of exchange-traded funds that function as foreign bank accounts offer both competitive interest and the prospect of capital gains if the U.S. dollar continues to weaken. Currency Shares British Pound Sterling Trust (FXB, news, msgs) is ahead 9.5% this year -- 40% more than the S&P 500 Index ($INX) -- and Currency Shares Euro Trust (FXE, news, msgs) has surged 14.6%.

Banks thirsty for cash

The remarkable resilience of cash is the upside of the subprime-mortgage mess. Rather than being tripped up by the credit crisis, money markets have benefited from it.

"The press keeps worrying about money funds breaking the buck, but all that investors have gotten so far is higher yield," says Peter Crane, the publisher of the Money Fund Intelligence newsletter.

In the current bout of credit mischief, no money fund has "broken the buck," or let net asset value fall below $1 a share. As for higher yields, thank free global markets.

Even as the Fed has been pushing down rates, banks have been pushing them up. LIBOR, the London interbank offered rate, remains at roughly 5%, near where it was in September.

"LIBOR is the most widely used benchmark in money markets. It's what banks are actually trading," Crane says. "The Fed funds rate is artificial; it's not a true market rate."

LIBOR has remained high because banks continue to regard credit markets as risky and therefore demand higher interest on loans, even to each other. Indeed, it's possible to find banks offering higher yields on your money than mutual funds because of competition among banks for deposits.

Bank-run money market accounts, which are FDIC-insured, can offer any yield a bank is willing to pay. Money market mutual funds, on the other hand, are not FDIC-insured bank accounts but rather investment pools whose yields are pegged to the interest they're actually accruing from their investments. Crane notes that the average yield of the nation's 100 largest money market mutual funds last week was 4.55%.

The yield last week on the pound sterling ETF was 5.24%; on the euro ETF, it was 3.77%. Both funds represent shares in foreign bank accounts denominated in those currencies, which have been strengthening against the dollar for more than five years.

Currencies can be risky

Currencies are wildly volatile, however, and for dollar investors these funds don't look anything like bank accounts. For one thing, you can lose principal. Between Nov. 29 and Dec. 11, for example, the net asset value of the pound sterling trust dropped 1.48%. In the same period, the euro trust went down 0.6%.

Currency volatility is greatly muted in foreign-stock mutual funds, including ETFs, and equity returns are usually much greater as well. So I've never regarded currency ETFs as attractive investments.

But if you hold substantial cash as a matter of course, adding these funds to the mix could provide diversification away from domestic interest rates and a degree of inflation protection. The European Central Bank, in particular, is a much more zealous inflation fighter than the Federal Reserve.

Also, I have owned both of these ETFs to hedge the cost of foreign travel. I buy the funds when I book a trip -- to lock in the exchange rate -- and sell them when I return. Brokerage commissions are much lower than the fees banks charge to purchase the actual currencies.

As the Fed continues to pull on the interest-rate string and as risk recedes in credit markets, money market rates are likely to decline. But for the time being they remain attractive. And don't automatically exclude your bank from consideration as a place to store your cash. It wants your money now even more than it usually does.

Meet Tim Middleton at The Money Show

MSN Money's mutual funds columnist will be among more than 320 investment experts sharing their strategies for 2008 at The World Money Show in Orlando, Fla., Feb. 6-9. Spend four days planning and refining your portfolio as you choose from more than 320 workshops and panel presentations.

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At the time of publication, Tim Middleton didn't own any securities mentioned in this article.