One of the under appreciated consequences of all the monetary easing and intervention that has gone on in the world since the credit crunch is the impact on central banks themselves. What I mean is that they find themselves holding ever larger sums of assets which in many cases they are compounding by often holding ever riskier ones. They are taking advantage of the fact that they are backed by national treasuries – although being backed by 19 national treasuries as the European Central Bank or ECB has a different perspective in my opinion – allowing the view that this is somehow risk-free to proliferate. Well it may not be risk-free for the taxpayers who find themselves backing all this!
The Bank of England
So far it has mostly confined itself to what we might call bog standard QE where it purchases UK Gilts. However it has been lengthening the maturity of its £375 billion of holdings in an Operation Twist style and now for example has some £989 million of our 2068 Gilt. Too Infinity! And Beyond! Indeed…
The main risk to taxpayers is in fact even less understood operations like the house price boosting Funding for Lending Scheme. Some £69 billion of cheap loans to banks have been issue here and should house price ever fall there are risks.
Foreign Exchange Reserves
These seem to be safe but the QE era has led to changes here because you see conventional theory has central banks investing in shorter dated bonds. Some of you will be spotting the problem already! This is how the Financial Times puts it.
European and Japanese (interest) rate cuts are putting pressure on many central banks’ returns — a source of income used to cover running costs and to provide finance ministries with profits on which they have come to rely.
In other words investing at negative yields carries a guaranteed loss if you hold to maturity which is awkward to say the least when you come to explain your stewardship to auditors and indeed taxpayers. The ECB in particular is hoist by its own petard here as I recall it arguing that value on maturity was the way of valuing Greek bonds back in the day and of course that is still convenient there. But not elsewhere. We have just excluded the Euro and the Yen which of course are major markets (even now some 20% and 4% of reserve assets respectively) and logical ones to put some of your reserves. So what are they doing? From the FT.
central bank reserve managers are making or “seriously considering” buying bundles of loans repackaged as asset-backed securities or switching out of currencies affected by negative rates.
There are issues here as we move from theoretically at least safe government bonds to what are less safe assets. There are in fact two issues which the FT does not point out so let me point them out.
The good news for central banks is that a consequence of their own actions is that they have made a profit. Of course they will not put it like that! No doubt the press communiques will concentrate on skilled management and their own abilities. But the QE era has driven the prices of the bonds they hold as foreign exchange reserves higher and hence bingo. Even the own-goal by former UK Chancellor Gordon Brown when he sold gold at what is now cruelly called Brown’s Bottom will look a little better as the replacement strategy of buying bonds does well.
The catch is for future investment as what do you do now with bond prices so high? Indeed these “independent” central bankers will be under pressure from politicians who have no doubt got used to spending the profits created for national treasuries to carry on regardless as the film put it. But where do they go now to do this? The FT gives us a nod and a wink.
But central banks have shed some of their conservatism in recent years, with monetary policies such as quantitative easing forcing them to sell bonds and buy riskier instruments such as equities.
Revealing language there via “forcing them”. Really? Many central banks are not allowed to buy equities for this purpose and so they will be buying longer-dated bonds and dipping into riskier ones. I will discuss the equity buyers in a moment but here is an idea of scale for you.
Total managed reserves were $10.9tn at the end of last year, according to the International Monetary Fund.
Even in these times of ever larger numbers that is quite a lot. By the way how do the numbers keep getting larger when we are supposed to be in deflation? Anyway the UK government has net US $ 38.4 billion which the Bank of England manages. Tucked away here is the issue that gross reserves are around US $97 billion larger as we mull we have liabilities too and the phrase what could go wrong? The bit we do know is that if it should it will not be anybody’s fault.
Moving onto a slightly different field which is QE then the ECB gave us an example of this in yesterday’s update.
Asset-backed securities cumulatively purchased and settled as at 15/04/2016 €19,220 mln……..Covered bonds cumulatively purchased and settled as at 15/04/2016 €169,255 mln.
The ABS securities are the riskiest and as an aside you may wonder Mario Draghi made such a big deal of them as in the scheme of things purchases have been relatively small. The US Federal Reserve has been a big buyer in this area and as it still hold some US $1.76 trillion does not seem to have been keen on realising the value stored there.
Equities and property
Here we find what I labelled the “currency twins” back in the day as there were many similarities between the Swiss Franc and the Japanese Yen. The carry trade pushed their currencies lower originally but reversing it post credit crunch saw them shoot higher which the respective central banks resisted. Here are the consequences.
Swiss National Bank
This has the equivalent of some US $600 billion to invest as a result of its past interventions and promises to take on all-comers. Of that some 18% was invested in equities at the end of 2015 and that is why I refer from time to time to it being affected by movements in the share price of Apple for example.
The equity portfolios in the foreign currency investments were comprised of shares from mid-cap and large-cap companies (excluding banks) in advanced economies and, to a lesser extent, shares of small-cap companies. The SNB does not engage in equity selection; it only invests passively.
I wonder what Swiss watchmakers think of their central bank using their money to invest in the creator and manufacturer of the Apple watch? But as we observe this I note that of course we do have what might be considered purist hedge fund behaviour here which is punting, excuse me invested in Apple shares. The equity component had also risen from 15% to 18%.
Bank of Japan
The Bank of Japan also has large foreign exchange reserves amounting to some US $1.26 trillion. All that intervention had to go somewhere or to put it another way we see why the Bank of Japan was reluctant to intervene again as the Yen surged a week or so ago. The Ministry of Finance is not keen on breaking this down but we do know that in its QQE (Quantiative and Qualitative Easing) policy the Bank of Japan is a keen equity and indeed property investor. From its latest Minutes.
Second, it would purchase ETFs and J-REITs so that their amounts outstanding would increase at annual paces of about 3 trillion yen and about 90 billion yen, respectively.
The Exchnage Traded Funds or ETFs are equity purchases and the J-REITs are property ones. So far just under 7.6 trillion Yen and 300 billion Yen have been purchased respectively. Indeed there are issues building here as regards market stability and structure. From Bloomberg.
the BOJ has accumulated an ETF stash that accounted for 52 percent of the entire market at the end of September, figures from Tokyo’s stock exchange show.
There is much to consider here as we see more and more central banks make the journey to what a Martian observer might have trouble distinguishing from a hedge fund. The elephant in the room is making investments which can make losses. Also here is a conceptual question for you. Is something a profit if it results from your subsequent purchases? The Bank of Japan which is both a template and the extreme case should be mulling this today in response to this.
JAPAN’S 30-YEAR YIELD FALLS TO RECORD 0.335% (h/t @moved_average )
In this situation it may already be beyond the point of no return which poses its own questions as it chomps on Japanese financial assets “like a powered up Pac-Man” as The Kaiser Chiefs put it.
Most other central banks have only taken relative baby steps on this road but we see that in yet another “surprise” even their foreign exchange reserve management is being affected. As I note that the ECB is the central bank mostly likely to dip into equities next let me leave you with a question. How is it that people who are badged as so intelligent and skilled seem to be so regularly surprised by the consequences of their own actions?!
For a minute there, I lost myself, I lost myself
Phew, for a minute there, I lost myself, I lost myself
For a minute there, I lost myself, I lost myself
Phew, for a minute there, I lost myself, I lost myself (Radiohead Karma Police)