Saturday, December 20, 2008

Cash Is Trash

From the Desk of Joe Rollins

It sure seems like our government is trying to convince us that “cash is trash” these days. In a time of incredible financial uncertainty, it appears that many investors feel more comfortable being in cash than in other types of investments. Cash seems to give investors a level of comfort that other investment classes just don’t seem to be able to provide. But I always find it ironic that people will flock to the malls to purchase clothes that are on sale while the average investor tends to avoid stocks at all costs when they are on sale.

There’s no question that the government is encouraging investors to take more risk and invest in stocks and higher yielding bonds. The interest rates being paid by government-guaranteed debt are staggering. The Federal Reserve System clearly has a plan: They are attempting to make cash so unattractive from an investment standpoint that even the most unknowledgeable investor will redeploy their cash into something that has the potential for a higher rate of return.

It may be hard to believe that as of this past Thursday, the benchmark 10-year Treasury bond sank to an annualized yield of 2.078%. That’s the lowest rate on a 10-year Treasury bond since November 1, 1977. A common barometer for mortgages is that they are priced 1.5% higher than the 10-year Treasury. Using the yield from Thursday, it’s possible that we might see a new mortgage rate at 3.6%. If we saw a 30-year mortgage at 3.6%, it would be the lowest ever recorded in the history of the United States.

You may recall my suggestion from a few weeks ago that the Federal government could solve the real estate issue in the United States by offering long-term mortgages at 4%. At the time I wrote that post, it was actually a stretch to get the rates down to 4%. Based upon yields from Thursday, however, it is not only possible, but it is likely that rates could soon be at 4%.

Even more astonishing than the rate on the 10-year Treasury bond is Thursday’s rate on the 30-year bond. It was only last Saturday that I wrote that the 30-year Treasury had briefly traded at the unbelievably low rate of 3%. Only five trading days later, the 30-year Treasury is yielding 2.547%. This is an extraordinarily low rate by any definition.

As I mentioned a few weeks ago, it would be very simple for the Treasury to enter the open market and issue 30-year Treasuries at 2.547% and then inject that money into Freddie Mac and Fannie Mae to make 4% mortgages available almost immediately. The Treasury hasn’t announced that they will do this yet, but I feel relatively sure that they’ve read my posts and that this will almost assuredly come to fruition at some point in January.

There is currently $3.76 trillion in money market accounts across the United States. Money market accounts are averaging a return of 1% per year, but this rate is falling dramatically and some of the major banks are already quoting money market rates at 0.2% on an annualized basis. It is hard to imagine why so many investors are willing to accept an almost minuscule rate of return.

I find it fascinating that almost 60% of the entire value of all traded securities in the United States is currently in money market accounts. Traded securities now approximate $7 billion after the significant haircut they’ve taken in 2008. Money market accounts now represent over one-half of the value of all the listed securities in the United States.

There is, of course, a major negative to the public concerning lower interest rates. Older investors who depend upon CD’s and other investments of this nature can no longer earn very good rates with these investment types. To support their lifestyles, even these investors will be forced into looking at alternative investments that will offer them a higher rate of return.

This past Tuesday, the U.S. Federal Reserve System announced that their overnight lending rate would be decreased to 0.25% annualized. On Friday, the Bank of Japan announced that they would be reducing their overnight lending rate to 0.1% annualized. I want to make sure that everyone understands that I’m not talking about 1% annualized; I’m talking about one-tenth of 1% annualized. Therefore, all of the banks in the United States and Japan can essentially borrow the money for nothing from the government. The U.S. prime rate is currently 3.25%. It doesn’t take a genius banker to figure out that they can borrow money from the Federal Reserve at zero and loan it to the general public at the rate of prime and earn a 3.25% spread on the use of the Fed’s money.

Those who argue that the reduction in the rate of prime means nothing to the average consumer are wrong. It may mean nothing to the traders on Wall Street, but it means a great deal to Main Street. Virtually all equity lines-of-credit enjoyed a rate reduction in 2008 from the prime rate of 7.25% at the beginning of the year to the incredibly low current rate of 3.25%. Almost all credit cards now have some sort of index off the prime rate. Coupled with the enormous reduction in fuel costs and the significant reduction in interest rates, almost all consumers have enjoyed a quasi-tax reduction in the last few months. The significant cash flow to the consumer in the reduction of gas and interest will ultimately improve consumer spending.

Even with the incredibly low interest rates illustrated above, the Federal Reserve doesn’t seem to be satisfied. On Tuesday of this week they announced that they would enter the open market and repurchase their own Treasury debt. The Federal Reserve’s purpose in taking this action is two-fold: First, it further forces down interest rates on this debt. Again, the government is trying to force investors in cash to redeploy that money into higher yielding investments. Second, and most importantly, the Federal Reserve System is trying to flood the economy with cash. Every time the Federal Reserve purchases security instruments, it replaces them with cash.

An investor previously thought that he was in a great long-term investment guaranteed by the government at a high rate of return. But the next day he finds that his bond is gone and that the government has replaced it with cash. Given that the alternative for investing that cash probably means an annualized return at less than 1%, then it is highly likely that this money will find its way back into stocks and bonds.

My purpose in providing you with the foregoing is not to focus on open market actions by the Federal Reserve. Rather, it’s to illustrate why the government is forcing interest rates so low. An important byproduct of these actions will be mortgages that will be available within the next six months that have never been available in this country before. These low mortgage rates will make homeownership available to virtually all Americans. With small 3.5% down payments on FHA loans, homeowners will be able to purchase homes with government-guaranteed mortgages as long as they have reasonable credit and are employed. Coupled with the new Federal tax credit of $7,500 on a new home purchase (a 15-year no interest loan to eligible taxpayers), buyers will be able to make a down payment and qualify for loans. With loan interest rates, anyone who can afford an apartment in America should be able to own a home.

The second benefit of these incredibly low interest rates is that it makes investors realize the folly of investing in cash. Today a one-month Treasury bond is yielding exactly zero percent. It will not be long before money market funds, based upon Treasury yields, will be negative. Additionally, taxable money market funds will continue to fall and before long all will be returning less than one-half of 1% annualized.

The day will soon come when investors realize that their cash is returning nothing and they decide to reinvest their capital in stocks and bonds. When this finally occurs, the $3.7 trillion currently invested in money market accounts will create an unprecedented rush of buying. It will be the most spectacular bear market rally ever recorded. I wish I knew exactly when that will happen – it could be a week, a month or even six months. The timing is clearly uncertain, but the fact that it will happen is now assured.

Clients often ask me why we do not sell out of stocks and bonds and put the money in cash until things recover. Quite simply, the explosive rally that will occur once the cash in money market accounts is reinvested will happen without warning. If you are not invested now, then it is likely you will miss that opportunity. Frankly, we don’t want to miss out on that opportunity and that is why we remain invested at all times.

With the holidays and the end of the year just around the corner, we realize that 2008 has been a difficult year. We greatly anticipate 2009 to be significantly better, and in fact, given all of the actions by the Federal Reserve, it could be a record year by all investment standards. We hope that you have enough confidence to participate in that recovery.

In the meantime, we wish each of you and your families a wonderful holiday season. We look forward to working with you in 2009.

Best regards,
Joe Rollins

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