Cash is a weapon during volatile times
Imagine you're the CFO of a successful business and you get a call on the Friday before quarter end. Your main supplier can offer you a 30% discount, but there’s a catch: you have to close a six-month deal today.
Sounds great if the cash can be wired out immediately. However, it’s not always that simple. What if the bulk of company cash is invested in a money market fund? What if it’s in a Treasury ladder or similar setup? These are considered liquid, but not instantaneous, and the instruments are rate-sensitive, meaning they may have a lower market price.
There are many reasons companies might need cash in a pinch. Acquisition opportunities, prepayment discounts, end-of-quarter contract bonuses, or snapping up overstock are only some of the myriad examples we’ve seen.
The chance to buy at a bargain price often materializes during times of higher volatility, such as the period we are now entering. Mayfair’s focus on low risk and high liquidity exists in part because we are former investors who’ve seen volatile markets. We understand not only the importance of liquid cash, but also what can happen to cash-like instruments usually considered safe when a market dislocation occurs, like the recent bond market rout.
What are the drivers and effects of market volatility?
There is no shortage of factors driving volatility. Bank instability itself is worrying, but the resulting increased regulation will also heighten volatility for at least some time. Labor unrest is widespread, and the US is currently dealing with its regular budget drama. US consumers are expected to run out of “excess savings” built up during the COVID-19 pandemic very soon. The knock-on effects can be expected to include sentiment turning negative, demand dropping off, and a hit to employment.
Higher interest rates on their own will logically increase volatility. Individuals arranged their finances in ways that implicitly were a bet on rates staying low—a strategy that is unfit for the current environment. Businesses designed capital structures and made investments predicated on low rates long into the future. Debt-heavy structures will break at higher rates, and the return on invested capital will decrease or even be negative.
The US government is increasing its borrowing with net issuance year-to-date the second highest year on record, which means higher coupons, and more budget pressure. This is happening despite an economy operating at full employment.
Because volatile markets result in chances to snap up bargains, cash is king. Cash has “option value,” because it allows you the option to strike while the iron is hot. Flexibility to react rapidly and pursue a good buy is often the difference between winning and losing.
What’s different today from past decades is that platforms like Mayfair exist, allowing firms to combine low risk and high liquidity with high yields and a great user experience. Companies used to have to trade off among those four variables, but for the first time in many people’s careers, that’s no longer the case. Fewer mistakes, more automation, and better insights ultimately mean more cash on the balance sheet at the end of every month.
Turbulence in the treasury market
What’s been happening in the Treasury market is a case in point. As we discussed at length in a recent piece on Treasury market developments, recent volatility levels are so rare they’ve only been seen a few times since the early 1980s.
The rise of rates to the highest levels since 2007 during such a short period of time has caused a significant decline in the value of bonds because yields move in the opposite direction of prices: as rates go up, the value of the exact same bond goes down, all else being equal. This is not a good position to be in if you’ve invested in longer-dated bonds and suddenly need liquidity.
Government officials worry about lack of liquidity, and the Federal Reserve has had to step in several times in recent years to make purchases that amount to trillions of dollars—hardly the sign of a functioning market. The Treasury market is clearly not at risk, but it is important to understand which risks you are exposed to by participating in buying and selling these securities.
Volatility is set to increase with the Fed’s multi-trillion dollar bond portfolio rolling off month-by-month. New issuance is increasing as the government becomes ever-more indebted, and yields will have to move higher to entice investors. It would not be logical to expect this market to calm down anytime soon.
Regulators worry about money market funds
Money market funds (MMFs) have not been immune to negative attention from investors and government officials over the past few years. Price, liquidity, and market risk are all top of mind at the Treasury, the Financial Stability Board, and the Fed.
In its 2022 report Money Market Fund Vulnerabilities: A Global Perspective, the Fed noted: “Operating in the niche between banking and investment funds, MMFs appear to offer the best of both worlds, with money‐like shares that pay market rates of interest. However, when crises have occurred, MMFs repeatedly have proven vulnerable and have failed to measure up to either the banking or the mutual fund models. Without the protections provided to bank deposits, the moneyness of MMFs is fragile.” (emphasis ours)
Inflows into MMFs have been so large that there have been knock-on effects in other financial markets. At the same time, a big concern among participants is a knock-on financial crisis related to the massive ebbs and flows of cash—something that has occurred in the past and led to periods of recession.
The Fed’s report identified price and value risks, including susceptibility to runs due to either sudden or heavy redemptions. It also found examples of lack of liquidity. such as when investors who requested redemptions from one fund in September 2008 had to wait several years before receiving their cash. And it identified market risks; for example, high similarity in MMF portfolios means that when one fund becomes unstable, others are likely to as well.
During the 2007-08 financial crisis, a loss in a single fund led to 29 other U.S. funds dropping significantly in value. Since then, in the U.S. alone, there have been significant periods of MMF instability during 2011, 2014, 2016, and 2020, which turned out to be worse than in 2008.
It’s time to pay attention to cash management
We’ve been in a bond bull market since the early 1980s, and for the past 15 years a combination of low interest rates and low inflation have meant that businesses didn’t necessarily need to optimize excess or reserve funds. However, when the environment changes, so must we. A do-nothing strategy doesn’t work in today’s market.
Companies need to focus on managing their cash effectively and efficiently. Think of these as muscles that need to be retrained, or in some cases have to be exercised for the first time ever.
Bargains abound in a volatile market such as the one we’re in today. Effective cash management allows you to move quickly when opportunities arise. Low risk and simplicity are key ingredients to execute this effectively.