The Cost of WaitingJuly 24, 2017
Depository clients have begun to hold higher levels of cash. Since the end of 2015 banks under $10 billion in assets have increased their cash equivalent balances by approximately 9% (FDIC). This is a result of recent rate hikes and probably more so due to the uncertainty regarding future rate direction. When investors feel uncertain they can become complacent and they choose to wait.
It is prudent to hold some level of cash but the opportunity costs from holding excess cash is usually higher than the defensive benefits it ever provides in the future. The longer cash or cash equivalents sit on the sideline the higher yields need to rise in the future to make up for the period of lost earnings.
The Federal Reserve’s current dot plot projects that the Feds overnight rate will go from 1.125% to about 3.00% over the next 3 years. The chart below take that rate environment and compares the 3 year cumulative interest income earned from immediately investing $10mm in a short-term money market tied to the Feds rate or investing fully in a 20 year 3.50% MBS pool yielding 2.60%. The MBS is longer with more interest rate risk but it still results in 50% more income. At the end of 3 years the federal funds position returns $618,751 in interest income while the pass-through returns $931,000. The up-front yield advantage of (2.60% vs 1.125%) and the reinvested monthly MBS cash flow far outweigh the benefits of remaining short.