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The Fed and Treasury Converge: Cash / Bills (Wednesday, December 17, 2008)

In recent weeks the Federal Reserve and the Treasury have converged. With interest rates on short-term Treasury bills around zero there is little financial difference between cash and treasuries. In fact, treasuries for some purposes offer advantages such as no limitation for FDIC coverage and treasuries are in book entry form unlike paper cash. Thus there is some record of ownership.

The policies of both the Federal Reserve and the Treasury and have forced rates lower for various reasons. The marketplace demand for preservation of capital is so great that there is little or no reward for holding these securities.

However, this convergence of events has narrowed future policy alternatives. The vast absorption of treasuries by financial institutions to avoid risk is now injecting a new risk into the system. Yes, treasuries are safe but only to a point and that point has been passed. This is because any increase in interest rates will produce liquidity and/or transactional losses. Moreover, the further one goes out on the yield curve, the negative pricing impact of interest rate increases magnifies especially at low or zero coupon rates. This is related to duration and pricing sensitivities. In a rush to secure liquid assets that can be readily marked-to-market, the financial system is now positioned that any future interest rate increases will damage balance sheets and income statements with even fewer safe havens. The reason is that these “potential” losses will impair regulatory capital for banks, brokers, dealers, insurance companies and other financial institutions. Regardless whether interest rates increase because of improvements in some economic sectors, flight of capital, currency devaluations or the like, the impact will be comparable to either cash currency or treasury securities when adjusted. .

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