Cash brings stability, liquidity, and optionality. For a buffer room and overall security, having some portion of your investment portfolio in cash is essential. Traders who still spend all their cash to remain “completely invested” will eventually face regular margin calls.
Bonds are a guarantee that currency will be delivered over time. Typically (but not always), they yield more than cash because of their duration.
With the coronavirus-related crash, US interest rates around the curve are down to zero and weak.
A 10-year bond gives you an additional yield of 60bps (0.6%) per year. Namely, concerning anything like a 3-month bill, which is a common cash proxy.
But 10-year bonds fluctuate more in price due to their duration. A one-percentage-point upward change in interest rates pushes the bond’s price about 10% (i.e., about its effective duration). It takes minimal movement in its price to wipe out far more than the entirety of its total annual yield.
The World’s Shortage of Dollars
In the downturn on coronavirus, the financial consequences will last 2-5 years after the downturn while it is an emerging situation. There have been around $5 trillion in losses in the US and more than $20 trillion in losses globally.
The Federal Reserve is the US’s central bank and can generate liquidity and credit to offset those losses and avoid balance sheet deterioration. But this money goes heavily to US companies under its purview and does not address the problems faced outside of the US by the bigger dollar-related losses.
After the US stock market peak before the virus-related collapse on February 19, 2020, emerging-market equities have underperformed US equities by around 5%, calculated by SPY (an S&P 500 ETF) and EEM (an emerging-market ETF) split.
Since the US dollar is the world’s currency in the sense that it includes 55 to 60% of the world’s borrowing, investing, and purchases, the world is desperate for dollars to replace profits and satisfy bonds. This scarcity increases the value of the US dollar.
Control over the development of the world’s currency means control over the most valuable asset in the world. It is especially true when they don’t have enough. Most institutions worldwide – individuals, companies, and governments – are searching for dollars, triggering a brief squeeze.
This upward pressure on the US dollar would inevitably diminish for one of two reasons:
- Combining domestic printing with foreign access (e.g., swap lines) would generate ample money to meet needs, or
- Defaults and restructuring would result in a decrease in the need for money*.
*Debt is a ‘short cash’ position. The debt must eventually be “covered” by paying out the money to whom it is due. When debt is stripped out or restructured, the obligation to cover those obligations in cash will either vanish or be reconfigured to a new scheme.
The US dollar will fall if that occurs.
This would also decline because those carrying USD-denominated debt will not want to keep holding this, provided the interest rates on it, both nominally and in real terms, are unacceptably low. Besides, when there’s a production of a lot of money, it reduces its worth.
Central banks would need to hold interest rates low because of the debt load for all parts of the economy, sovereign, corporate, individual. There will be negative real returns and negative returns compared to other asset groups. Which will do better as markets “reflate” (e.g., corporate credit, stocks).
When the coronavirus struck, causing companies to shut down and customers to withdraw, it harmed company profits and balance sheets (i.e., more debt, fewer savings).
When several companies (e.g., creditors, private sector owners, individuals, banks) had to liquidate assets to raise cash to help fulfill their debt and other payment obligations, it triggered a decrease in asset prices.
Stock markets in the US plummeted about 35% in a few weeks. This made cash look attractive by comparison because its value doesn’t move around much.
Nonetheless, what steps did central banks take to combat this asset and downturn in the economy?
They had to lower interest rates on cash for a very long time, with practically no risk of raising rates in emerging markets. Global short-term debt rates are now below 1%.
Besides, central banks purchased a lot of government debt and “printed” an unprecedented amount of money to purchase other credit assets, helping push up prices. To help keep businesses alive, it reduces the cost of capital.
This is close to the era from 1930 until just after World War II ended.
Short-term interest rates reached zero, and long-term interest rates were also kept low by “yield curve management”. Different collateral types were backstopped.
There were the Fed’s capital production and financial assets’ acquisition, both traditional monetary policy types. What kind of financial assets they buy depends on what policymakers want to conserve. What are the costs and benefits associated with letting different entities fail?
Throughout the financial crisis of 2008, politicians agreed it was fair to let Lehman Brothers and Bear Stearns fail. (I.e., wipe out shareholders and most of the creditors’ available claims). But save other institutions.
The current crisis goes beyond the financial system and into almost every other industry. Beyond the basics (e.g., Proctor-Gamble) and e-commerce forms (e.g., Amazon) and digital entertainment forms (e.g., Netflix).
The U.S. federal government would not let companies like Boeing collapse for economic and security purposes.
Depending on how many people they hire, how many customers they transport, and what their loss will mean for the business climate, airlines are in the same boat.
American Airlines (AAL) and United Airlines (UAL) 5-year bonds are quoted at yields of around 20%.
UAL’s 5-yrs (4-7/8% coupon) on the dollar are at 60cc. Efficient yield reaches over 18%.
The risk is a default, bailout, and/or future big government stake at an 18% yield. Italy took full control of Alitalia, the largest national airline globally, providing a critical service. In the US industry, there is more competition and distinction, so the nationalization level is impossible.
If airlines were a free enterprise, they would be bad investments, as they have been traditional. But if and when necessary, the federal government would provide them with plenty of capital. It’s less about the notional intrinsic principle in these situations and more about the belief in offering assistance to those worth saving.
The US government, including the Fed (which regulates monetary policy) and the central government (which regulates fiscal policy), is in a position to offer money and credit guarantees selectively.
The ability to have the most powerful reserve currency in the world is, once again, a major advantage.
The US accounts for just over 20% of global economic activity. The US dollar currency accounts for nearly 60% of all borrowing, lending, purchasing, and selling activity.
This mainly helps US people. The ECB will be looking after the broader euro area and those that need euros. The BOJ will take yen from Japan and those wanting it. The PBOC will get Chinese companies yuan (aka renminbi) to help make up for lost revenue and the inability to pay off their debts.
Emerging-market countries, where global demand for their money and debt are small, do not gain nearly the same degree.
Why Cash Is, Over Time, the Worst Investment
Although cash volatility is low, it receives a negative return in various ways:
- Real return and sometimes negative nominal return (on certain debt maturities even now in the United States)
- Returns in terms of various types of goods and services
- Long-term returns concerning other financial assets (‘risk premiums’)
With time, these negative returns add up considerably. Missing 2% annual returns (i.e., a traditional risk premium of bonds over cash) over thirty years means missing out on combined returns of 81%.
Missing out on 4-5% annually (as in a standard cash spread in equities) for over thirty years means missing out on 3.2x to 4.3x ROI.
Cash, which is money now not bearing interest in the entire developed world, is important to have in some quantity.
But to other types of assets, it is a long-term underperformer – particularly assets that retain their value or increase their value during periods of reflation.
Bondholders are increasingly asking whether the bonds they carry, which are paying negative real and nominal interest rates, are quality wealth stores.
Additionally, vast sums of money are being generated to better address current debt issues and offset missing incomes. That depreciates its long-term value. (In the short run, excess supply currency demand tends to support the currencies in which it is relevant.) Emerging dollar bonds give higher yields but are risky alternatives. First, they borrow in a foreign currency, but in domestic currency, they make their profits. Provided their currency to reserve currencies is less in demand. Emerging market currencies usually decline in downturns, just like other risk assets.
Some countries are on USD, including Ecuador, to which they switched due to an earlier crisis that ended in 2000. They don’t have the opportunity to print more of it, which falls entirely under Federal Reserve power.
Other nations, such as major oil exporters like Saudi Arabia, Oman, Qatar, and the UAE, use USD as a traditional peg to promote global confidence in their currency values.
Countries with low demand for their domestic currency do not use much (or at all) as global reserves. Their ability to assist their economies is low.
This restriction pushed down demand for bonds and currencies (i.e., prices) and increased yields.
The decline in oil prices has hit commodity exporters hard. Importers of commodities can see some relief from lower energy prices, but their own economic problems with the virus have more than offset any savings in this regard.
India, an important oil importer, in particular, is suffering. India’s overall spending on public assistance has reached just 0.7% of GDP, which is very short of the 10-20% average typical in developed countries. The financial system has already been in difficulty going downward.
Approximately 25% of all government debt on the emerging market is at risk of moving into distressed grade territory.
Most emerging markets have been financially unable to deal with the storm with much less capacity to stimulate their economies than developed markets. For a good reason, their debt is cheap.
Will they Ever Refund the Debt?
It’ll never be paid off in the US and developing world.
There are three principal ways in which governments can pay their debt:
- cut spending
- raise taxes
- create money
We eventually go with the third because of the limitations of cutting spending and raising taxes (harmfully impacting people to vote those governments out).
Government debt and long-term pension and healthcare liabilities (which are several multiples of the headline debt figure) can never be paid off by growth results resulting in a tax-taking of government spending that will then potentially go on paying down and more than maintaining long-term debt.
Printing money comes with problems of its own but is the least painful choice. Nonetheless, many policymakers and analysts seek more of it, mostly because the implications are clearly far-off or not well-known.
Will All the Spending Be Inflationary?
That can definitely be the case in the financial sector. When the financial sector receives liquidity, it gets into cash. A financial asset’s price is money and loan expended on it, divided by the quantity. Central banks are the main driver of financial-market liquidity, so paying attention to them is especially important.
The inflationary aspects of money production are offset in the real economy by the deflationary impact of the gaps created in profits and balance sheets (i.e., lower expenditures).
It is an exercise of money development where more will fall on the government to buy it (or directly monetize it) than on the private sector, which will challenge the debt assets’ value (i.e., currency provided over time) while obtaining negative real and nominal return rates.
Citizens will have to determine progressively whether negative-return assets (i.e., cash and bonds in reserve currency countries) are good wealth stores.
Accordingly, they would have to decide their options for alternative investment assets (e.g., gold, stocks, real estate, and other real property).