How many central banks will turn into hedge funds?

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.

Riskier bonds

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)



10 thoughts on “How many central banks will turn into hedge funds?

  1. strange isnt it ?

    as the economy staggers along , all the debt seems to be piled onto the poor tax paying middle classes ( the poor dont have the cash – the rich hide theirs )

    so lets extrapolate – CB buy all the Banks equity paper , which I believe at one time was referred to as “phantom ” assets ,

    then what ? the CB are either going to go bust whilst the private Banks walk off debt free ? or
    make a killing as they control the market ?

    Shhhh! dont mention the “free market ” , more like the “fee market “!


    • ‘all the debt seems to be piled onto the poor …..dwindling ……tax paying middle classes’

      Word added for effect Forbin.

    • The real issue is going to come when the stock market starts tanking.There’s only so long you can drive earnings with buy backs.

  2. ‘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 good news for central banks is that a consequence of their own actions is that they have made a profit’

    So it’s the plan is working while it’s working.

    Hope,despite the old adage,is apparently a strategy.

    On a side matter Shaun,can you confirm these currency reserves aren’t included when we measure GDP against the national debt?

    • Hi Dutch

      Yes it looks really good when it is working, for example any central banks holding UK equities will be cheered by this evening’s close above 6405. The problem is when equity markets fall as will they then have to add to it by cutting losses or double up? Either has its problems….

      As to your question it depends which version of the national debt you use.

      1. Eurostat ( and by inference ratings agencies) I believe not as it is gross government debt with no netting off.

      2. UK ONS . Yes as the PSND is a net and not a gross measure.

      “Liquid assets, such as bank deposits and foreign exchange reserves, were
      subtracted from the consolidated gross liabilities to give ‘net debt’. ”

      The Japanese for obvious reasons are very keen on a net debt number and the last time I checked it was 154% of GDP…

  3. Central banks piling into asset backed securities. No James Bond villian has ever tried such a sure way to destroy economies, it’s too ridiculuous for fiction.

    They have no reliable way to rate the risk of ABS nor reliable means of valueing the collateral. There were identical issues with US mortgage backed securities …. cavaet emptor.

    • Hi ExpatInBG

      Mario Draghi was very keen on ABS buying for a while before purchases began. He was clearly asking banks and financial institutions to create them so he could buy them. I assumed it was a way of getting some of the bad debts of the books of the banks and those in Italy especially. That means however that the Euro are taxpayer is likely to be wondering about the meaning of “asset” when the time comes to sell them! Forbin has already pointed out the problems that the Bank of England had with “phantom securities” provided as assets for its Special Liquidity Scheme back in 2010/11.

  4. When central banks buy their own government debt it really is the left hand borrowing from the right hand. Presumably these government bonds can in principal simply be cancelled at some point if needed thereby rendering any capital loss irrelevant? If so then its a comforting position for central bank “hedge fund” managers – either make a profit on the bonds or cancel them. My guess is that just as may other former financial orthodoxies have been broken (eg negative interest rates) so too will such debt cancellation occur at some point – my money would be on Japan to move first. There must be a big downside to this accounting trick though otherwise it would be used regularly.

    • Hi Redshift and welcome

      There are two main issues and the first is that you have increased the money supply. That may not seem a big deal at a time when the velocity of money has been low but should it pick up there would be problems with inflation. Central bankers boast they could fix that easily. Odd then that they were poor at controlling the money supply in the past!

      Next it would shatter any remaining illusions that central banks are indeed independent.

  5. “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?!”

    Answer = A morally corrupt establishment, where promotion is based on favouritism and nepotism with the one swear word being “meritocracy”, and every one in the West questions the Chinese establishment!!!!

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