Wednesday, December 17, 2008

The coming cash conundrum and the return of the carry trade

The Fed has promised to keep the funds rate at or close to zero for "some time." That's reminiscent of a similar pledge in late 2003, when the Fed kept the funds rate pegged at 1% until June 2004. Exceptionally low interest rates back then helped fuel the housing bubble, helped drive gold and commodity prices up, and the dollar down. The carry trade was born.

This time around the yield on cash and cash-like securities (e.g., money market funds) is going to be even lower. Indeed, MMF yields could approach zero and force fund companies to slash their fees in an attempt to keep yields positive. And lots of money could flow out of MMFs and into bank CDs in search of better yields.

The larger issue, however, is the conundrum than those holding cash or cash equivalents for risk-reducing purposes will face: it only makes sense to hold zero-interest cash if the prices of alternative investments continue to decline. If other asset prices just stabilize, they will yield more (and in the case of high-yield bonds, for example, much more) than cash. And of course if other asset prices rise, their returns will be hugely more than cash.

In short, if the economy doesn't continue to deteriorate significantly, then cash will prove to be a major embarrassment. With the underlying fundamentals (e.g., swap spreads, agency spreads, implied volatility, liquidity) improving, the economy is not likely, in my view, to deteriorate enough to keep the prices of other assets declining. Thus, as time passes, investors will be compelled to trade in their cash (or increase their borrowings, since borrowing costs will be extraordinarily low) in exchange for riskier assets. And that in turn will set off a virtuous cycle to the upside which could be rather spectacular.

The Fed put us on a roller coaster ride beginning in the late 1990s, and the ride continues. Just as signs are emerging that the unwinding of "carry trades" is coming to an end, a new cycle will soon begin. Just as deleveraging and forced selling slowly exhaust themselves, a new wave of re-leveraging and buying will begin. Who can resist buying extremely cheap assets with money that is almost free?

No comments: