Sunday, March 11, 2012

US Treasuries - the new cash!

The economist in a recent article has described the increasing use of US treasuries as cash by many investors. I have been thinking about the nature of money and wealth in general and have increasingly come to believe that this is not an oddity.

Some context first: I have argued in my earlier post, that the stock of global financial capital will keep growing at a very large pace. It is obvious to anyone that observes the workings of modern economies that a part of the cumulative savings in a given year get added to the investments of this year and leads to further increase in savings stocks - also termed wealth. I will write about the nature of wealth seperately later. It is interesting to note however that the rate of increase of savings stock is only going to go up as it benefits from the accumulation effect (something similar happens to stock of knowledge as well, though sadly there limits on human creativity soon start to block further progress!).

As the savings stock goes up, the investors are increasingly going to want to park it somewhere. While a part will go into the risky assets, a large proportion will nevertheless go into "safe assets". The safest asset of course is cash. However, there is not enough cash to hold the trillions of dollars of wealth in the world today. What is the next best thing? US treasuries.

If you observe carefully enough, you will realize that short of being accepted for exchange of goods and services (for now!), US treasuries resemble the ordinary US Dollar in many ways. They are both the obligation of the US government. They are both unsecured. They are both fairly liquid in terms of exchange value. And lately, thanks to QE, they both offer zero interest!

The similarities are neither superficial nor temporary. The world, as it turns out, does need something of the sort of "cash" to hold its wealth - which it does not wish to deploy into anything risky. If we revisit one of the reasons of mortgage backed securities becoming so popular, it is plain that the demand for safe assets is very high - large enough to prompt bankers to concoct artificial treasuries (As the safest tranche of the Mortgage Backed Securities).

As the demand for this cash goes up, the prospect of negative interest rate on US treasuries will become quite real. How is negative interest rate plausible? One goes back to the analogy of the locker. The locker is provided as a service and the owner of the locker is charging one for the safety assured. In a similar vein the US government is now looking to charge a premium for the safe keeping of the investors' funds that it assures (even with a AA+ rating! what a shame S&P?!).

How long will this go on? Probably for a long while. Even after the QE ends and the US as well as the world returns to moderate growth path, the demand for cash is not going anywhere - Sovereign wealth funds, pension funds, less optimistic common investors will all demand more and more of US treasuries over the time to come!

What does it mean? It means there is more financial wealth in the world than it needs. The US government is in essence a proxy for parking it with a safe enough borrower till the world sorts itself out. A shake-out like 2008 will repeat and cause some more reduction in paper wealth. However everyone wants to guard against losses in such a shake-out. Hence they will continue to park in the new-found cash till the mess concludes. The deeper issue is that the financial wealth will start diminishing slowly (through inflation as well as an explicit negative interest rate on treasuries if it arrives) even as everyone waits for the wealth reduction to conclude. But the massive ocean of liquid wealth that this will keep building will keep the financial world a very turbulent affair for a long time to come!