Prices of short-term Treasuries dropped earlier this month, pushing two-year note yields to the highest since September, after a report showing continued jobs-market strength boosted bets the Federal Reserve may consider raising interest rates sooner than forecast. The nation’s economy added 288,000 jobs in June, following a 224,000 gain the prior month that was bigger than previously estimated.

The median forecast in a Bloomberg survey of economists called for a 215,000 advance. The jobless rate fell to 6.1 percent, the lowest since September 2008. The number of long-term unemployed fell to 3.1 million, showing workers are having greater success finding work.

Stock markets, meanwhile, reached record levels on the back of gaining economic momentum and central bank support. The Dow Jones Industrial Average rose above 17,000 for the first time and the Russell 2000 Index recovered nearly all its losses from a two-month selloff of Internet and small-cap shares. The Dow Jones Transportation Average also rallied to a record on the strength of global manufacturing.

The fall in the jobless rate prompted many observers to pull forward the forecast for Fed tightening. Traders pushed up their bets for a June rate increase to 49 percent from 33 percent at the end of May. The consensus sees a 1 percent target by the end of 2015 and 2 percent by the end of 2016, from the 0 percent to 0.25 percent that has prevailed since December 2008.

Longer-term bonds have confounded most investors this year. Yields were expected to rise throughout 2014 as the Fed cut back on its quantitative easing program, but instead are well below where they stood in January. To the surprise of analysts, investors remained desperate for income in the first half of the year, bidding up bond prices.

Against this backdrop, investment officers face a dilemma; to invest now and lock in current income or keep cash levels high and invest when rates may be higher. Many are still trying to time the market, waiting for the right level to put cash to work.

Some financial institutions keep cash on hand at about 5 percent of assets. Others fund their daily operations through overnight wholesale borrowings, such as FHLB advances, brokered CDs or other sources. Since 2008, this option has been more profitable. By maintaining cash in excess of projected needs, institutions bear a high opportunity cost and may in fact be making a bet on interest rates.

Achieving Breakeven

The biggest issue with trying to time the market is the potential loss of earnings. Excess liquidity earning 25 basis points or less can drag on earnings. Although current investment yields are not optimal, the spread compared to overnight funds is still quite large on a historical basis.

Consider an example where an institution is holding an extra $10 million in cash. In the base case, all the cash is invested now at 2 percent. The cash is invested in the second scenario 12 months from now after investment yields have increased 0.75 percent (or a 2.75 percent investment yield). In the third scenario, the funds are also put to work at 2.75 percent, though 24 months from now.

The base case produces a three-year interest income total of $600,000, compared to $575,000 for the second scenario and $325,000 in scenario three. Even if the investment yield increased another 100 basis points for scenario three to 3.75 percent, the horizon income only improves to $425,000. In the alternate scenarios, trying to anticipate the market results in less income over time because of the yield give-up while waiting for rates to rise. The longer one waits, the more interest income that is forgone.

Another way to measure the opportunity cost is looking at the investment yields required at various horizon dates to compensate for staying in cash. For scenario two (investing after year one), the break-even yield is 2.875 percent. For scenario three (investing after year two), the hurdle rate is 5.5 percent. Further out in the future, it becomes very difficult to make up the lost ground.

The cost of waiting can readily be quantified by comparing the opportunity cost of lost earnings. As always, the benefit of “income today” should be balanced against the impact on capital of market value fluctuations of investments in a rising rate environment. The price risk can be managed, however, by adding intermediate-term securities that provide stable cash flow and with the potential to “roll down the yield curve.”

While much attention has been paid to the recent decline in rates, most of the action centered around the long end. Yields in the four- to five-year part of the yield curve have held up reasonably well, and are only about 10 basis points off their September peak. For investment officers holding excess liquidity, this steep curve affords an opportunity to improve earnings without taking on undue risk.

Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford. He can be reached at bob@atlanticcapitalstrategies.com.