The Liquidity Trap

Two things are common among virtually all of our clients in the current economic environment. One, is that there is an uncomfortable level of Earnings pressure. The other is that banks currently have more liquidity than they have had in decades. The first condition is obviously bad. The second is more ambiguous.

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It has been said that "having too much cash is like having too much runway." We are often comforted by feeling secure about certain things, even if they may not work in our best interests. This is what Lord John Maynard Keynes had in mind when he developed the concept of the Liquidity Trap back in the 1930's.
 
Without going into the details of his theory, the current situation is a proto-typical case of what he saw as a huge concern. As people behave in a manner that they think is unquestionably in their best interests, their financial and economic well-being is undermined in a clear and persistent way.
 
Many Investors see their increased liquidity as essentially a good thing. Although they clearly recognize that there are short-term costs, they are confident that there will be substantial long-term benefits. This seems to be a compelling case and, as a consequence, some never bother "doing the math" to see if their comfort level is well founded or possibly illusory.
 
In the table below we have done the math and it presents some problematic questions. The table illustrates the financial trade-off between holding Short-Term Liquidity and Intermediate-Term Investments (5 years). It illustrates the trade-offs of holding one type of investment vs. the other over the next several years (discussed below), in six-month segments. It illustrates the Opportunity Costs of holding one investment position vs the other, and it further computes the Yield required for the next 12-month period in order to recover those lost Earnings, based upon each Million Dollars invested. As you can see, these trade-offs are relatively benign in the early stages of the analysis but develop into some "attention grabbing" figures relatively quickly.

Some may have a tendency to look at this table and say, "I know, but I feel better with the Liquidity." If so, why? The Fed says that they do not anticipate raising rates for at least three years. If the Investor held off for this entire period, then that would mean that the holder of the Liquidity would have to reinvest at a minimum of 5.85% just to "break-even" for the next 12 months.
 
Goldman Sachs just indicated that they believe that rates will not rise for at least five years. This would elevate the break-even rate to 8.75%.

The skeptical investor may reject both of these estimates as having no impact upon their outlook for rates and their subsequent propensity to desire liquidity.

Which brings to mind recent history. The Fed last lowered the Fed Funds Rate to the Zero Bound range of 0-25bps in December of 2008. They didn't raise rates until December of 2015, seven years later. Their next increase was in December of 2016, at which time they only raised it an additional quarter, to 0.75%.
 
This analysis clearly has implications for both Earnings and Capital, but there is a good chance that it is neither Earnings nor Capital that is creating such a strong preference for Liquidity. Rather, it may be "Valuations." Many investors hate to see brackets around their Investment Gains/Losses. However, I would suggest two things: One, there are tools for correcting Portfolios stuck in a High Rate Environment. Two, go back to December 2018 and examine your Portfolio, your unrealized Gains/Losses, Balance Sheet, and Earnings Statement. Do you prefer then or now? If you prefer now, a large Liquidity position is best for your bank. If you prefer then, you may want to continue to maintain/pursue a fully invested position even though it continues to make you very nervous each and every day.