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Summary

  • Factors that influence the optimal level of cash, and how cash balance can affect portfolio performance.
  • Charts showing retail and institutional cash balances.
  • One strategy to benefit from a steep yield curve.

What is the proper level of cash for an investor to hold? That is a catch-22 question. With 20-20 hindsight, during the start of a bull market a low level of cash might be ideal. While a high level of cash balance might be preferred during a bear market. Unfortunately, investors and savers do not have the benefit of 20-20 hindsight.

The age of the investor and their risk profile will be important factors to consider when deciding upon an optimal level of cash. There is no easy answer to what is the proper level of cash to hold.

Cash can be king. Cash can also be a drag on performance. Cash can permit an investor to add to a position during a swift downturn in price or valuation. Without the cash or the ability to borrow, there is no ability to benefit from a temporary setback.

What has happened to money fund cash levels?

The chart below shows institutional money funds, retail money funds and total money market mutual funds.

The general trend has been for higher levels of cash to be held in money funds. Retail money funds are below its 2000 level, while institutional money funds are higher than the 2000 levels. The past few years have seen a flat line for total money fund holdings.

Cash per Capita:

On a per capita basis, money fund balances have been in an uptrend, and more recently have stabilized. Rising per capita money fund holdings occurred during the 1990s' bull market, as the federal government budget was in surplus and there was solid economic growth. It could be that rising money fund balances signal an expanding economy.

Yearly Change in Cash:

The year-over-year trend in money fund balances has been improving. This could be suggesting an improving economic situation.

Cash sitting on the sidelines in the past enjoyed earning a few percentage points, or greater, of interest income. This has not been the case more recently, yet cash balances remain elevated. Why? I would speculate it is partly a function of fear.

Fear is a powerful emotion that can lead to irrational investment decisions.

Fear of what?

  1. Fear of another stock or bond market meltdown
  2. Fear of job loss
  3. Fear of lost credit
  4. Fear of not having a backup liquidity as unused lines of credit were cancelled or reduced during the last downturn
  5. Fear of higher interest rates
  6. Fear of a spike in inflation
  7. Fear of the unknown
  8. Fear of the Fed

It should be noted that if one has cash (asset), another has a loan (liability).

Can you remember when short-term interest rates were in the double digits? I can. When interest rates fell into the single digits, there were howls about hurting savers. Sounds familiar? Savers could have locked in double-digit interest rates for a number of years by giving up a little liquidity. Investors and savers should realize there is a trade-off for having instant liquidity, and it is a lower rate of interest.

Should the Federal Reserve engineer a steeper yield curve, then investors/savers that park cash for a longer term could earn a more attractive rate of interest. This could provide a nice profit center for financial institutions and investors by riding the yield curve.

How could investors benefit from a steeper yield curve?

A steeper yield results when longer-term interest rates are greater than shorter-term interest rates. The greater the spread, the steeper the yield curve. For example, on March 23, 1992, the 1-year Treasury bill yield was 4.74%, with the 2-year Treasury note yield at 5.87%. The 2-year less 1-year spread was 113 basis points. An investor could lock in the 5.87% yield by buying the 2-year Treasury note. If the money were needed after one year, then the issue could be sold, and if the then 1-year yield were 4.87%, then there would be a gain on the investment.

A steep yield curve can permit an investor to increase the maturity of an investment, say buy a 2-year issue with plans to sell it after 1-year. By extending the maturity, a higher rate of interest can be earned; however, the increased maturity increases the risk of loss, should the investment need to be sold before maturity. A steep yield curve can help reduce the risk of loss. Currently, the 2-year less 1-year spread has averaged roughly 30 basis points. The 30bps is the incremental income improvement by extending the investment by a year, from 1 year to 2 years.

Source: Institutional And Retail Cash On The Sidelines