Is Cash No Longer Trash?
Short-term bond yields (one-month through three years) are hitting their highest levels in over nine years.
Why?
The market (Fed Funds Futures) is expecting the Federal Reserve to hike rates three more times in 2018:
- A 25 basis point move in March,
- a 25 basis point move in June, and
- a 25 basis point move in September.
This would bring the year-end Fed Funds Rate to a range of 2.00-2.25%, its highest level since September 2008.
So is cash no longer trash?
That depends on your definition of "trash." If by "trash" you mean a nominal rate close to 0%, then yes, it is certainly not trash anymore. But if by "trash" you mean an interest rate below inflation (negative real yield), it would still hold that moniker.
A positive real yield (yield above inflation rate) is something cash-like instruments have lacked during much of the past nine years as the Federal Reserve has maintained easy monetary policy far longer than any prior period in history. The Fed held short-term interest rates at close to 0% for seven years (December 2008 to December 2015) while inflation was still positive (averaging 1.7% per year), meaning cash holdings failed to keep pace with rising prices. During this period, "trash" was a fair depiction, as the loss of purchasing power was over 12%.
Data Source: BLS, Stern.NYU.edu/~adamodar, FRED
In December 2015, the Fed finally raised rates off of 0%, but thus far it has been the slowest hiking cycle in history with only five quarter-point hikes in the past two years (current range of 1.25-1.50%). Inflation averaged 2.1% in both 2016 and 2017, meaning "trash" was still a pretty accurate depiction.
But with the Fed expected to hike this month (to 1.50-1.75%) and again in June (to 1.75-2.00%), cash is becoming less trash-like by the day. If inflation holds steady (currently at 2.1%), we could see positive real yields by year-end.
Data Source: BLS, Stern.NYU.edu/~adamodar, FRED
Before 2008, a positive real yield was a reasonable expectation from a cash-like instrument. From 1948 to 2007, the median real three-month Treasury bill yield was 1.3% with 73% of months showing a positive real yield.
But there was a dramatic change after the financial crisis. The median real three-month yield has been -1.4% since 2008 with only 12% of months showing a positive real yield.
The last time we saw an extended period of negative real cash rates was during the 1970s and early 1980s when Treasury bill yields often failed to keep pace with rising inflation. That would end when Paul Volcker "broke the back of inflation" by hiking the Fed Funds Rate up to 20% in 1981.
The two periods of extended negative real rates couldn't be more different. In the 1970s, the fear was runaway inflation, and while the Fed often hiked rates in an attempt to combat it, it did not move quickly enough until Volcker took control. After 2008, the fear was deflation, and Ben Bernanke and Janet Yellen held rates at artificially low levels in an attempt to increase asset prices (houses, stocks, etc.) with the hope that would stimulate the economy.
While the 1970s showed extreme volatility in the inflation rate, in period since 2008 inflation has been remarkably stable at close to 2%. What has changed since December 2015 is the Fed's reaction to that inflation rate, where it has become more confident it will meet its long-term objective (2%) and increasingly satisfied with the reflation in asset prices (housing/stocks at all-time highs).
For short-term bond investors, this normalization in rates has undoubtedly been a welcome change. But what does it mean for other asset classes when cash is no longer trash? I'll explore that question in an upcoming post.
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