Investment managers often talk about the cost of excess liquidity. But liquidity may also have value. The value can be realized as ready cash to make up for unplanned shortfalls in revenue or acceleration in spending , or to take advantage of  a rise in interest rates that increases earnings potential from re-investments.

Liquidity management should now be front and center. The recent election raises the likelihood that state and local governments will experience unplanned changes in revenue and spending because of macro-economic events like the pace of economic growth, or changes in Federal (or state) grant programs in the middle of a budget cycle. Disruption is the theme of the new Trump administration and the Republican-led Congress and should be factored into portfolio and cash management strategies.

Liquidity has value should, at least temporarily, replace the liquidity has cost approach.

The details. In ordinary times, when focused on the cost of liquidity, portfolio and finance managers start by plotting cash flows and liabilities and forecasting cash requirements to “optimize” cash balances. That’s fine for an analysis in a static market and where overall yields do not change over time. It is also supported where yields on longer-maturity investments are higher than those on short-term investments so there is something to be gained by extending maturities. But the first assumption (a static market) cannot be counted on, and the second currently is not true (the yield curve has a negative slope).

To address these limitations investment managers use break-even analysis. Investing in maturities that do not exactly match liabilities means that the investor will have to reinvest for the gap period, thus taking on reinvestment risk, or sell investments prior to maturity. It is straightforward to quantify the risks involved by calculating the interest rate for a follow-on investment that would produce the same interest rate as a longer-duration investment over its life—the so-called break-even rate--or to calculate the rate that would have to prevail to produce a desired cash flow when the plan is to sell an investment before it matures.

Focusing on cash flow forecasting as a basis for constructing a portfolio is a useful discipline, but it is useful also to think about the value of having cash in hand. In uncertain times liquidity has value, not cost. Imagine you were offered liquidity “insurance.” What would you pay as a premium or guarantee fee to be able to turn your investments into cash on a moment’s notice? If you think of paying paying ten or 20 basis points to "insure" the immediate liquidity of a portfolio, this might seem reasonable. But how about giving up ten or20 basis points of yield to maintain a balance in a money fund or LGIP vs. the earnings you might receive in a portfolio whose cash flow meets presumed liabilities?

Another aspect of the cost vs. value analysis confronts an investor who selects a longer-tenor investment to meet a shorter cash flow requirement. They will incur a cost for breaking the investment in advance of its maturity. This cost could turn into a benefit if the yield curve is positive and the investment is liquid, so that it can be sold at a yield that is lower than its purchase yield. Or it could be a true cost if, as in current circumstances, the yield curve is negative or if rates rise beyond a break-even level when the investment is sold.

Liquidity is especially valuable when investors face a high degree of uncertainty. Girard Miller points out in a recent article in Governing that the re-election of Donald Trump is likely to lead to what he characterizes as a seismic shift in Federal tax and budget policies. About 25% of state and local government revenue comes from Federal grants--$1.3 trillion in 2022. A significant portion of these grants may be cut or re-structured as the Trump administration pursues its goal of eliminating $2 trillion of Federal spending.  But the magnitude and timing of any changes are not known today.

Add to that the uncertainty as to the future level of interest rates. The Federal Reserve embarked on a path of reducing its main policy rate (the Federal Funds rate) in September. Normally this should lead to rates falling across the yield curve as investors anticipate still lower rates ahead. But in fact rates have risen since the September Fed meeting. Five-year Treasury notes are up by about 90 basis points. (A five-year note purchased on September 18 would have lost nearly four percent of its value at this point.) Why? Because investors doubt the Fed will continue to cut rates and see some chance that Trump economic policies will lead to higher rates.

Investors have bulked up balances in LGIPs and money funds (Cranedata reported last week that money fund balances have exceeded $7 trillion for the first time). Some commentators have opined that this is “lazy money” or money sitting on the sidelines waiting for a good time to jump in to the market, but a plausible alternative explanation is that they may be simply applying a rational approach to investing in a period of great uncertainty.

Bottom line. Policies and economics change when a new administration arrives in Washington, but this time around the uncertainty seems heightened. Maintaining extra liquidity, which may or may not have a cost (depending on the future path of interest rates) seems like a prudent response.

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Consumer Financial Protection Bureau Head Calls for Reforming FDIC Insurance

Speaking (or writing) of uncertainty, it’s hard to handicap any action by Washington policy makers until we learn something about the work of the nascent Department of General Efficiency (the Musk/Ramaswamy effort), and in particular the extent to which Congress will be involved. So it was interesting when last week the chair of the Consumer Financial Protection Bureau called for Congress to reform federal deposit insurance.

Rohit Chopra who, by the way, is sure to be replaced in the new Trump administration, thinks the limits on deposit insurance should be eliminated, or at least raised significantly, for payroll and other non-interest-bearing operating accounts.

In Chopra’s thinking this would level the playing field between big banks where, he argues, depositors have a de facto guarantee on all deposits—because the failure of the bank would disrupt the financial system—and small banks, where the insurance program is the only backstop.

Chopra’s statement called attention to the October failure of the First National Bank of Lindsey, OK. This was a small bank, with slightly more than $100 million in assets.  What fed Chopra’s narrative is that about $7 million of deposits were uninsured and were not included in the rescue of the failed bank. Depositors received access to 50% of their deposits, with some further payout possible as the bank is liquidated.

News reports noted that at least one local government deposit was affected by the holdback. Under Oklahoma law public unit deposits in excess of insured amounts are required to be collateralized. But the bank may not have followed through on this requirement. Just because a law requires something doesn’t assure the request is met. And when an obligor fails to perform and becomes insolvent, options for recovery are limited (and costly).

Reminder, if a reminder is needed, that collateral requirements do not guarantee timely or full recovery of deposits.