Sub-Zero Yields on Treasury Bills; Liquidity Trap?

Bespoke Investment Group observed on its blog that the 3-month U.S. Treasury Bill Yield recently dropped below zero as investors seeking a safe haven for their cash pile into short-term treasuries.  A yield below zero is the equivalent of lending money to the government, and paying it for the privilege, rather than the government paying you for borrowing your money.  Crazy?  It certainly seems that way.  But maybe the economy will get so bad that paying the government to hold your money will seem like a good idea.  Apparently, to some investors, it already is.

We should not make too light of this situation, however, because it raises the spectre of a something akin to economic quicksand – a liquidity trap.  When nominal interest rates fall to zero (or below), the opportunity cost of holding cash dissipates.  In other words, one might as well literally stuff money in the mattress if one cannot loan money and receive a return on the investment.  Liquidity traps can occur when prices are falling (a deflationary cycle) and the Fed lowers rates to spur borrowing and lending.  No investor wants to buy assets because the prices keep falling, and then, when interest rates fall toward zero, investors and lenders begin hoarding cash, as there is no longer any disincentive (inflation or better opportunity for returns) to holding cash.

One reason we are approaching a liquidity trap now is that our banking industry faces a balance sheet crisis.  Thus, even though the government shifted its goals for the Troubled Asset Relief Program and began investing directly in banks, the financial industry is not using that money to lend.  Part of the reason is that rates are so low and balance sheets so fragile, that banks are hoarding cash to protect themselves.  That is why borrowing rates are not improving (although mortgage rates have come down thanks to a different government program) despite the Fed lowering its federal funds rate to 1 percent and massively increasing the money supply.

Another issue during a period of deflation that adds to the liquidity trap concern is the fact that the real value of nominal liabilities increases and thus, real interest rates increase as the nominal rate trends toward zero.  To put this in clearer terms, imagine you bought a house for $100,000 and have an $80,000 principal balance on a mortgage.  That leaves $20,000 of equity in the asset, the house.  But then housing prices drop, and now your house is only worth $80,000.  The mortgage has not changed and the mortgage interest rate has not changed either.  However, the real value of the mortgage and the interest on the mortgage has gone up, because now you are paying the same amount for an asset that has dropped 20 percent.  In order to regain the nominal equity in the house, it will be necessary to reduce the mortgage principal by $20,000, which is 25 percent of the mortgage and, now, also 25 percent of the value of the house.  Now, let’s say $20,000 falls into your lap from the sky.  You can invest it and earn zero percent, you can pay down your mortgage, or you can hold onto it and wait.  Most consumers in this environment will hoard cash, just like the banks are doing now, until a clear choice can be made, because the other alternatives are too unattractive.  And here is the problem from the macro economic point of view, $20,000 was added to the economy, but it went into the mattress and so, it had no stimulating effect on the economy.

The liquidity trap is why the government needs to refocus away from simply easing access to money and concentrate on fiscal stimulus and, more importantly, restructuring banks’ balance sheets.  I believe the government will take all three of those paths in the coming year, will which spur a temporary improvement in the economy and the stock markets.  But the resulting inflation, continued lack of consumer spending, and lack of a jobs recovery will likely tip the economy into stag-deflation sometime in 2010.  This is when we could see the stock market hit some truly ugly lows (no, we have not seen the worst, but it will look like it is getting much better over the course of the next year—use it to your advantage, but do not be fooled).

By the way, if any of you cash hoarders out there are thinking a money market fund is the best place to be right now, please read this article at Bloomberg.com: Money-Market Fund Yields May Fall to Less Than Zero.