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The Cash Management Impact of the Fed’s Rate Cut: How to Minimize Risk and Maximize Return

Changing yield-curve dynamics are going to have a significant effect on risk-return tradeoffs in cash management. In response to reduced interest rates, financial institutions would be wise to consider a robust cash preservation approach that combines scenario and sensitivity analyses.

Friday, October 4, 2024

By Alla Gil

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Now that the Federal Reserve has started cutting interest rates, the shape of the yield curve is going to change – and cash management strategies must be reviewed.

Cash management is a critical task for treasurers and CFOs across industries, especially in the companies that need to balance liquidity with return on capital. Financial institutions need to maintain sufficient liquidity to meet regulatory requirements and to cover operational needs. Meanwhile, cash-rich corporations – such as tech and pharmaceutical companies – must ensure they have enough liquidity for potential acquisitions or research and development of new products.

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Today, in an environment of reduced rates, the challenge of cash management lies in striking the right balance between preserving principal and achieving optimal returns, without exposing the company’s cash reserves to excessive risk. Investing in highly illiquid or volatile securities is generally not feasible for these purposes, as they could jeopardize liquidity and stability in the event of unforeseen cash needs.

Considering Yield-Curve Dynamics

The decision of how to manage risk-return alternatives is largely influenced by the shape of the yield curve. There is a strong negative correlation (≈75%) between the level of interest rates and steepness of the curve. Higher interest rates are typically associated with a flat yield curve, while lower interest rates often coincide with a steep yield curve (Figure 1).

Figure 1: The Yield Curve/Interest Rates Connection

f1-yield-curve-241004

 

Source: Federal Reserve Economic Database. The figure depicts historical data for the one-month Treasury rate and highlights the difference between the one-month and 10-year Treasury rates.

Given the yield curve uncertainty, a risk manager’s goal is to preserve capital while accruing as much interest income as possible. This means optimizing the tradeoff between higher-interest rate instruments, which might be subject to mark-to-market (MTM) volatility if they need to be sold before maturity, and low MTM risk instruments, which might have lower yields.

In an upward-sloping, steep yield-curve scenario, longer-term bonds yield more than shorter-term ones, rewarding investors for the risk of locking up capital over a longer period. The steeper the curve, the greater the temptation to invest in longer maturities for higher returns. However, this strategy introduces MTM risk if interest rates fluctuate, or if the bonds need to be sold before maturity.

A flat yield curve occurs when the difference between short-term and long-term interest rates is low. The income from the short-term and long-term instruments is similar in such an environment, so staying at the short end of the curve becomes an attractive (good income/low MTM risk) option.

However, over the long-term horizon, the situation might change abruptly, particularly during a period of an inverted yield curve. Typically, investing in money market instruments seems to be a no-brainer – until the longer-term risks are considered.

Transitioning from an inverted yield curve with high interest rates to an environment with a steep yield curve and normal-to-low rates is one of the biggest cash management challenges. When interest rates are expected to decline and the yield curve is transitioning from inverted back to normal, treasurers must carefully assess the timing and structure of their investments.

If rates fall too quickly, the opportunity to lock in higher yields on long-term bonds could be missed. On the other hand, if rates remain higher for longer than expected, moving too early into long-duration bonds could expose the portfolio to MTM volatility.

Cash Management Strategies During Transitions

When faced with a potential shift in the yield curve from inverted to normal, it’s not enough to apply the standard risk-return optimization based on historical data. During such a situation, full-range scenario analysis must be complemented with trend sensitivity.

Interest rates tend to mean-revert to their historical average, which can be quite different in various historical periods. Risk managers might therefore consider historical periods with dramatically different mean-reversion levels, as shown in Figure 2.

Figure 2: Sensitizing Mean Reversion Levels

f2-sensitizing-mean-241004

Source: Straterix

There are two trends depicted in Figure 2: a nearly 35-year history of high average levels and a recent three-year period characterized by very low rates that were assumed to be a “new normal.” While generating scenarios around these polar-opposite trends, it is possible to identify a robust allocation that will keep cash levels above the initial point and generate decent income along the way.

Figures 3 and 4 show the results of such sensitivity analysis, with different levels of mean reversion. Here we assume that the coupons are reinvested in the respective instruments: i.e., if the rates went up and MTM went down, the coupon can buy more of a relevant bond – and vice versa.

This type of reinvestment assumptions should be applied over a three-year horizon. Available cash is calculated as the sum of MTM of a respective instrument and its interest income at that point in time. This should be calculated every quarter, across the next three years, for each scenario at each point in time. If no cash is needed at a specific point, the coupon gets reinvested, as described above.

Figure 3: Available Cash Distribution, with Mean Reversion to a 35-Year Historical Average

f3-cast-investment-outcomes-241004

Source: Straterix

Figure 4: Available Cash Distribution, with Mean Reversion to the Lowest Three-Year Historical Average

f4-cash-investment-sensitivity-analysis-241004

Source: Straterix

Comparing the results in Figures 3 and 4, we can conclude that the three-year instruments are way too risky (the worst-case outcome is below par in both cases), at least initially. At the same time, three-month and one-year instruments perform similarly well, barely ever touching a floor of 100. (In both examples, the one-year investment is slightly better than the three-month investment.)

This type of analysis can be performed for the combination of instruments. Any “barbell” or “ladder” strategy should be run through such a sensitivity check, across all scenarios.

Don’t Forget Investors

One additional factor that a financial institution must consider when adjusting its risk-return approach to cash management is the investor mindset.

Investors often hesitate to focus too much on risk reduction, fearing it may limit returns. However, it is crucial to differentiate between "good" risks and "bad" risks.

"Good" risks are those that, while carrying the possibility of downside, offer meaningful upside potential. "Bad" or tail risks have little or no upside and represent irrecoverable outcomes, depending on the context.

For example, for bond investors, tail risk might be a corporate default. For pension funds restricted to investment-grade assets, a downgrade to below investment grade means they need to realize their losses.

For corporate treasury teams managing cash, meanwhile, a tail risk event could be missing their capital preservation target. And for a financial guarantee insurance company, even a single notch downgrade could have a significant impact on its operations.

Parting Thoughts

As interest rates begin to fall and the yield curve returns to a more traditional slope, treasurers will need to carefully evaluate the tradeoffs between locking in yields at the longer end of the curve and maintaining liquidity for short-term needs.

The challenge is to manage both rate and reinvestment risk effectively, ensuring that liquidity is preserved while maximizing returns during uncertain economic periods. This careful balancing act is essential, because it can protect a company’s financial health while allowing it to continue to pursue strategic growth opportunities.

Cash management is not just about safeguarding the principal; rather, it’s also about making strategic decisions that optimize return based on current and expected market conditions. Understanding yield-curve dynamics and selecting the right instruments for each phase of the curve can make a significant difference in a company's ability to manage cash effectively.

 

Alla Gil is co-founder and CEO of Straterix, which provides unique scenario tools for strategic planning and risk management. Prior to forming Straterix, Gil was the global head of Strategic Advisory at Goldman Sachs, Citigroup, and Nomura, where she advised financial institutions and corporations on stress testing, economic capital, ALM, long-term risk projections and optimal capital allocation.




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