I see that “cash on the sidelines” is back in the news. I have a high-conviction view on a technical aspect of this that I will reiterate here. This take would not likely exert a major influence on asset markets at any horizon, even if it were right, which it certainly is. But I so seldom see this issue treated properly, as in never, that I figure it is easy to add a little value here simply by not being trivially wrong.
It is literally impossible for cash on the sidelines to “flow” into an asset class, including a riskier one. So, if there is cash on the sidelines at S&P 5,000 or UST 4%, there will be roughly the same amount of cash on the sidelines at S&P 10,000 or UST 3%, if the repricings happen quickly relative to the flows of net issuance. What observers call “cash” is invariably somebody else’s liability, which investors cannot extinguish, obviously. And that cash is mostly federal debt and derivatives of that such as insured deposits.[1]
For example, if I were to own $1 million of 3-month bills and decided to allocate to more risk, I might sell those bills to someone else and then buy equities from someone else. This would move the price of the risk assets and maybe even the bills to a much lesser extent. But the outstanding stock of bills would not be affected by this transaction. Nor would there be a net “flow” into risk assets. Somebody else would be buying bills and selling equities, although in response to the price changes, not as a driver of them. As a private citizen I cannot retire the Treasury’s liabilities or increase the corporate sector’s liabilities. Somehow this escapes “cash on the sidelines” analysts.
Here is what they mean to say. If there is a rising stock of risk-free assets, as has been the case recently, then portfolio balance effects associated with that should move up the price of risk assets relative to the price of risk-free assets, inclusive of the term premium, where relevant. The steep rise of the federal debt in recent years has probably contributed to a higher r*, perhaps a higher term premium, and a decline in the equity premium over risk-free assets. Relatedly, the lower equity premium would probably be associated with a higher market capitalization, which would lower the stock of risk-free assets relative to the market capitalization of the riskier asset. So, there are two ways that markets equilibrate in the presence of a rising stock of risk-free assets, which some people like to call “cash.” But for god’s sake, there is no net “flow” to speak of. And looking for that flow or referring to cash on the sidelines without taking account of relative valuation or capitalization is, erm, innocent.
If you have internalized that, then here is a fun one for you. How about the guy who expects bonds to rally because there is so much “cash on the sidelines,” i.e., federal debt?
The practical point here is that waiting for cash on the sidelines to come off the sidelines would be a horrible way to time the stock or bond markets. You might as well wait for the Treasury to run a fiscal surplus. Like, literally. In fairness, though, I would not expect capital market prices to gap tomorrow morning if analysts somehow decided to get this one right.
[1] I suppose if I had currency or a bank deposit and decided to retire credit card with that, then I would be extinguishing my own liability. But I cannot retire yours. Sorry,
