When everyone is crowding around the feeding trough, it can be hard to see who is providing the food. So it is with cash rates right now, at least in my eyes. i think it is time to air a word of caution on interest rates for cash. Not necessarily the usual worry of losing money (it is cash after all…) but the loss of focus that occurs when you can’t see what’s feeding the trough. It’s a financial-planner-thing, and if you are good enough to share some time with me and read this post then i’ll share some history, thoughts and perspective with you.

Term Deposits and “The Herd”

Term deposit rates in Australia are the marvel of the developed world. Savers in Germany, France, the United States, the United Kingdom and Japan shake their heads in amazement when they ponder our relatively very high interest rates, wondering “how do they manage to make that work?” (in much the same way that city workers gaze up at the growing Perth Arena…)

Australia’s term deposit rates are currently at historically large premiums to the ongoing cash rate or to pretty much any similar benchmark of late. There is a huge volume of cash that has been seeking the safety and certainty of returns being offered by term deposits.

Australia’s banks have been reducing their reliance on overseas and short term funding in favour of increasing their “deposit base”. Lending off cash is generally seen as a safer form of banking than lending out money that you have also borrowed, especially when you have to borrow that money on a world stage beset with worries about credit-worthiness and debt in Europe, the UK, USA and Japan. In addition, the international banking standards “Basel III” changes are encouraging banks to compete for more retail deposits, simply because these deposits carry more weight when measuring bank reserve ratios.

So it’s a win-win and no wonder the rush for term deposits has resembled a “herd” migration. Australians get higher term deposit rates, and the banks they invest in become “safer” in a technical sense as they have less exposure to global financial conditions.

Cash rates and Risk

Don’t wanna be the wet blanket at the party folks but it seems to me that many in The Herd are forgetting some of the old basics of investment. Remember…

When there’s a higher return, there’s a higher risk

or

If they are paying more than they should, the risk is greater

These two old, old concepts are easy to forget when Australia’s banks and institutions are so strong and solid. When they are highly rated on even a global scale. When institutions in charge or huge cash piles (Apple, Microsoft, sovereign funds, pension funds) are prepared to keep buying Australia’s fixed income investments even when the rates on offer fall to 40 year lows from an Australian viewpoint. In the face of all this, how can little ol’ Michael possibly suggest that there is any risk in cash?

Quite simply, i see risk in cash because the asset class is currently exceeding its natural limits. It’s breaking these two old rules.  This means someone, somewhere is buying deposits. That is, giving up profit or margins in an effort to get more “stuff”. That has historically been a red flag for potential risk and right now i see that flag raised high and flapping madly in the wind. Here’s a little history lesson in cash investments, and how easy it is to be lured into the idea that cash is cash is safe is good.

• Pyramid Building Society
• Rothwells
• Estate Mortgage
• Tri-Continental
• OST Friendly Society
• Westpoint
• Cambridge Credit

These are names that some will remember but many will not – and that can be fertile ground for setting up the next repeat. There’s a great tome available on the internet for the insomniaces out there – Fifty Years of Managed Funds in Australia – a report for the Australian Financial Services Association (“AFSA”). It’s a fun read if you are interested in what has gone right and what has gone wrong with financial services over the years. Google is a bit young for some of these names but you can still find articles of interest if you spend time on it.

Now before all those nerdy folk get on their high horses to start berating me for denigrating the good name of Australia’s cash institutions…

Not all risks are a loss of capital

Please understand that this note is not suggesting that higher interest rates on cash will lead to collapse or loss of capital. That’s something for analysts, ratings researchers and history to map out – not the terrain for a lone financial planner of far more limited resources. My interest is in the outcomes that play out when all this focus, marketing effort and cash is directed towards encouraging investors to move to one area. This post was prompted by yet another marketing email from a bank, offering cash rates “well above the RBA cash rate of 3.50% p.a.”

It’s a bit like the ridiculously shrill calls of “bankruptcy!” that reverberate around the United States at the moment whenever anyone talks about the US Government financial position. Sometimes the longer term story just gets lost in the noise of the moment. If anyone’s interested then i’ll happily show how the USA’s finances are exactly where you would expect them to be right now, and how “standard” the position is when viewed historically. But back to the point at hand…

Cash is King is times of volatility and uncertainty. In the 5 years (five. years. !.) since the first rumbles of the Global Financial Crisis the “wall of worry” facing investors has risen and fallen with horrific regularity. Naturally, an investment that preserves capital and provides some hope of keeping up with inflation in the very short term is a great place to be, and a natural backstop for most investors. However, it is easy to forget that cash does not generally allow you to much more than keep up with inflation. If you take into account taxes then you aren’t usually going to even get that far.

So eventually there is going to be a lot of pressure to look elsewhere than cash in order to find investments with a possibility of making money over and above inflation.

That’s where i see the real risk here…

The higher interest rates currently on offer are a strong incentive to stay in cash or to increase the amount of money allocated to cash. In a volatile world, more cash simply makes you look and feel a lot better (Michael technical talk). However, the world of banking is still working its way through one type of crisis or another, and when that finally stops being a primary directive then there isn’t going to be the same incentive to hold cash. At that point in time, banks will start lending for something more risky than an absolute certainty (if you doubt my thought process then simply consider the current UK efforts to force banks to lend), and the risk/return metrics will start to become a little more balanced.

At some stage, people (companies/institutions/governments) will stop paying the German and US governments fees to hold their cash. They’ll stop investing into 30 year investments virtually guaranteed to lose capital after inflation and they will stop assuming that the global financial system is about to collapse. When they do this, there will be a fair amount of competition to get into areas with the potential for growth. Right now those areas are priced at historically low levels compared to the “safe” cash areas.

Growth areas such as shares and property, are not just low – they are being pushed even lower in part by people who think they should be lower still. That is not supposed to impact the value of the businesses or markets over the longer term – but you can be absolutely certain that it impacts in the short term, and that’s most people’s investment timeframe right now.

Cash is not always King

Cash is the king of the short term playground, and a big bully at that. However, its size and importance diminishes over time. If you doubt this, just ponder why any rathional, thinking individual would bother investing in a property or shares or businesses, when they could achieve solid, reliable returns via term deposit?

Remember the Great Disclaimer – Nothing here is to be deemed personal advice, and you must not act on what i write or say or even imply without first taking appropriate action through research and professional investigation.  i’m not suggesting you dump your cash and buy some great “growth” story. I’m not suggesting banks or financial institutions are going under. i’m just saying that there are risks and there are risks, and in terms of the average person’s long term financial planning, price volatility is not always the biggest one.