Why does money keep flooding into the short-term Treasuries market, or T-bills? It is a fascinating question, given last week’s US rating downgrade – and the fact that yields on three-month bills are now a mere 0.01 percent. There are plenty of explanations around: investors are searching for safe havens; terrified about growth; worrying about deflation; chasing momentum. Or all four.
But there is another factor investors should watch: what companies and asset managers are doing with their spare “cash”.
Earlier this week, the International Monetary Fund quietly published a ground-breaking paper on this issue, written by Zoltan Pozsar, a visiting scholar and former central bank economist. And while the analysis is couched in dull, central bank language, the conclusions are utterly fascinating, not just in relation to the current markets swings – but also future systemic risks.
The issue at stake revolves around the “cash” which companies, asset managers and securities lenders (such as custodial banks) hold on their balance sheets. Two decades ago, these cash pools were modest, totalling just $100 billion across the globe, with individual companies typically holding just $100 million, or so. But in recent years, these pools have exploded in size, as the asset management sector has consolidated and companies have centralised their treasury functions. Institutional cash managers now control between $2,000 billion and $4,000 billion globally, and Pozsar reckons on average there is $75 billion sitting at individual securities lenders, $20 billion at asset managers, and $15 billion at large US companies.
That is startling. But what is more striking is where this “cash” has ended up. Two decades ago, it typically was placed in bank accounts. But in recent years, cash managers have started to avoid banks: in 2007, for example, just 16-20 percent of these funds were on deposit. Why? Pozsar thinks the key factor was risk management, not yield. From 1990 up to the crisis, US Federal Deposit Insurance Corporation only guaranteed the first $100,000 of any account. And while cash managers have tried to use multiple banks, their cash pools are so large that effective diversification is impossible. Thus they have hunted for alternatives that seemed liquid and safer than uninsured bank accounts, such as repurchase deals (backed by collateral), money market funds (often implicitly backed by banks), or highly rated short term securities (such as triple A rated asset backed commercial paper or mortgage bonds.)
Pozsar argues that this has created a big distortion in the monetary aggregates (ironically, cash is only counted as M2 “cash” in the Fed’s accounts if it is held in a bank.) He also thinks this pattern was a little-watched factor behind the boom in shadow banking before 2007. He is undoubtedly correct.
But the really interesting issue is what is happening now. After the 2008 crisis, the FDIC raised the insured account limit to $250,000, and that has prompted cash managers to raise the proportion of funds they place on deposit to 33 percent. However, surveys suggest they will not go further – meaning that trillions of dollars still sit outside the banking system. This creates some potentially big systemic risks: as Pozsar notes, the amount of institutional cash held outside FDIC-insured bank accounts – and thus outside government umbrellas – is now two thirds of the size of the money which is protected by the FDIC (up from just 5 percent in 1990). This could provide the source of another panic if a crisis hits, since it is unsure whether banks could really protect, say, money market funds.
But the “vacuum” also affects asset prices. Since 2008, large parts of the shadow banking world have all but collapsed. Thus cash managers are now frantically searching for new places to put their “cash”. Some has flooded into money market funds (which buy government bonds) or the repo world (often backed by bonds); some money has entered the T-bill market directly. Either way, the net result is a shortage of T-bills, particularly since banks and clearing houses are also gobbling up T-bills for regulatory purposes.
Hence the low yields. From an investment perspective, these returns may seem crazy; but they are still attractive to cash managers because T-bills are liquid – and, most crucially, seem less risky than uninsured bank deposits. Or, put another way, faced with a choice between betting on the safety of the US government, or its banks, cash-rich large companies and asset managers are choosing the former. It is an entirely rational choice. But it is also a powerful reminder of how profoundly distorted the US financial system remains. And that is not a comforting thought; least of all in a rollercoaster week.