Why the Cost of Cash Is High

(MoneyWatch)  If you own cash, one-month Treasury bills or money market accounts, you've no doubt noticed the low yields, or high "cost of cash." By cost of cash, I mean the difference between these instruments and those with higher expected returns such as stocks. Here's why the yields on these instruments are so low.

• First, the financial crisis created a huge demand for liquidity. Investors sold risky assets and moved to cash. The large demand for very high quality assets of very short maturity drove yields down.
• Second, while the demand for short-term assets increased, the demand for short-term liabilities fell. This happened because overall demand for debt was falling due to the economic slowdown.
• Third, lending institutions and corporations were trying to improve the liquidity of their balance sheets, resulting in a reduction in the demand for short-term debt as they attempted to extend maturities of their liabilities.

The bottom line is that increased supply and decreased demand led to a sharp drop in the price of money, or interest rates. This increased cost of cash caused exactly what the Federal Reserve desired -- investors began seeking higher returns by once again investing in riskier assets such as stocks and corporate bonds.

The following data shows first the flight to liquidity and safety, and now its unwinding. At the beginning of 2008, total assets in money market accounts were $3.2 trillion. By March 2009, that figure had grown to $3.9 trillion. By September it had fallen to $3.5 trillion. The shift out of money market accounts has helped fuel the rally in virtually all risky assets all around the globe that we have seen since March. And as you can see, there's still plenty of fuel left.

Besides investing in riskier assets, you can also increase yields by extending maturities of Treasury bonds. Doing so allows you to earn the term premium, which you earn for taking the risk of unexpected inflation. There's also an investment that allows you to earn the term premium without taking inflation risk: Longer-term TIPS. Currently, five-, 10- and 20-year TIPS are providing real yields of about 0.9, 1.6 and 2.1 percent, respectively.