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The cash conundrum revisited

I began getting very bullish back in December 2008, having observed numerous signs of improvement, most notably declining swap spreads and the Fed's aggressive expansion of the monetary base. In one post around mid-December, "The coming cash conundrum and the return of the carry trade," I wondered how long it would take people to realize that holding lots of cash (a very popular idea at the time, given how fearful people were that the end of the world as we know it was approaching) would be embarrassing. After all, holding cash that pays zero interest only makes sense if the prices of riskier assets decline; if they just hold steady, riskier assets beat cash due to their higher intrinsic yield. If, as I thought, a recovery was in sight, then the deleveraging that characterized 2008 would soon reverse and releveraging would return to fashion. I was a little early calling the low in the stock market, and the return to releveraging took a lot longer than I thought (see my post yesterday on this subject), but with the benefit of hindsight, dumping cash at the end of 2008 and buying stocks was a very profitable strategy: the total return on the S&P 500 since late December has been about 65%, vs. almost nothing for cash.

So, more than three years later I ask the question again, amazed that it still needs asking: how much longer will the public be content to sit on a mountain of cash? Especially now that the economy has been growing for the past two and a half years, swap spreads are back to normal, corporate default rates have plunged, corporate profits are at record highs, residential construction is beginning to turn up, job growth has picked up, and cash still yields zero? Can the economy's prospects be so dismal that it still makes sense to hold zero-yielding cash in the belief that most other assets will decline in price?

According to ISI, domestic equity mutual funds have suffered net outflows of some $355 billion since Sep. '08, with $155 billion of that occurring since last April, and $6 billion so far this year. While investors have shunned the equity market, the demand for safe-haven cash has been intense. Since September '08, households have socked away just over $2 trillion in bank savings deposits that pay next to nothing (see chart above). Moreover, the banking system has been content to sit on $1.5 trillion of excess bank reserves (see chart below) that pay only 0.25% per year (i.e., the proceeds from the sale of MBS and Treasury notes and bonds to the Fed). Apparently, there is still lots of fear out there, and there seems to be no shortage of gloom and doom predictions.

But turning a blind eye to the alternatives to cash requires a deep conviction that the future is going to be miserable. Consider: the average yield on investment grade corporate bonds is over 4%; REITS are yielding 4%; the average yield on BAA corporate bonds is over 5%; the average yield on junk bonds is over 7%; and the earnings yield on the S&P 500 is over 7%.

Ignoring those very attractive yields in favor of zero-yielding cash also means paying no attention to the Fed's very explicit desire to convince the public that holding cash makes no sense at all, and it's only a small logical leap to the corollary that borrowing money makes lots of sense. It rarely pays to fight the Fed.

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