What happens when a central bank becomes a hedge fund?

It is a sign of the times that we need to sub divide the intervention by central banks but we do. So today I will not be looking at the sovereign bond buying of which, for example, the Bank of England will deploy some £1.473 billion this afternoon. As this is state to state action although some still live in a sort of delirium where the central bank independently does this.

What I am referring to is where the central bank buys private-sector assets. For example if I switch to the European Central Bank or ECB then in its latest published weekly data it bought three types of private-sector bond. The largest has been of Covered Bonds of which the various programmes total  290 billion Euros with 1.5 billion bought that week. Oh and you will not be surprised to learn that this went on well before the ECB started general QE and it benefits the banks.

 A bank sells a number of investments that produce cash, typically mortgages or public sector loans, to a financial institution. That company then assembles the investments into packages and issues them as bonds. ( Investopaedia)

A rather similar effort is the purchase of asset back securities about which you may recall ECB President Mario Draghi making quite a song and dance a few years back. Anyway in spite of the hype this has not amount to much in the general scheme of things at 30 billion Euros and 600 million added in the week.

It is hard not to have a wry smile as I note the purchases across the rest of the economy are smaller than those to help The Precious! The Precious! As the corporate bond programme totals some 247 billion Euros with 1.9 billion bough that week.

The issue here is twofold. The ECB is exposing itself to a genuine risk of loss and it is favouring some parts of the economy over others. That starts with favouring the banks and moves onto helping larger rather than smaller companies leading to more risk of Zombification. All of that gets a much bigger risk of the central bank sings along with David Bowie.

Fashion, turn to the left
Fashion, turn to the right
Ooh fashion
We are the goon squad and we’re coming to town
Beep-beep, beep-beep

Here is Isabel Schabel from late August.

One idea that I have been pushing a bit in recent months is the idea of a green capital markets union. The idea is to combine the whole reform process for capital markets union with the green transition. I think there is a huge potential there for Europe. It would help a lot and would also – in an uncontroversial way – allow us to buy more green bonds.

What could go wrong? Especially as she seems to think she and her colleagues know better than financial markets.

 And there is the alternative view that markets are not pricing climate risks properly, so there is a market distortion.

Equity Purchases

Bank of Japan

These add a new level of risk as at least in theory bonds offer more protection for an unwary central bank. So let me start with what brought this subject to my mind today.

Tokyo’s benchmark stock index started December in some style. The Nikkei Average enjoyed its highest close since April 1991.

The index ended Tuesday at 26,787, up 1.3 percent from Monday’s close. Investors placed buy orders in a wide range of sectors from the opening.

Tuesday’s bounce came after news that US pharmaceutical firm Moderna has sought regulatory approval for its COVID vaccine. They say it was 94 percent effective in clinical trials.

The strong start to December followed a month that had the Nikkei firing on all cylinders.

Vaccine news and the US election result helped boost the index by 15 percent. ( NHK News)

So the Nikkei 225 index had a pretty stellar November and that theme has continued today. However we learn something by noting that even a month where it rose by 15% the central planners at the Bank of Japan still felt the need to buy equities twice as they bought a bit over 70 billion Yen on the 13th and the 18th. This is a road to a situation where their equity holdings now exceed 35 trillion Yen which is why I have described it as The Tokyo Whale in the past. Putting that into context that is the equivalent of owning Toyota which is Japan’s largest company more than one and a half times.

The Bank of Japan acts passively and buys exchange traded funds ( ETFs) aiming to match the Nikkei 400 index.So with the concentration of equity markets these days it will not be much different to the 225 index as even in it the smallest 40 rarely traded even in my time working there. It also buys smaller amounts ( 1.2 billion Yen) of both commercial property REITs and equities to promote physical and human capital. In fact it does the latter most days.

For those of you unaware of this I guess I have given you a completely different perspective on the Japanese stock market and in particular on its rise.

Swiss National Bank

It too is an equity buyer but this time of foreign equity as its road to here was via its enormous foreign exchange interventions as it has battled the rise of the Swiss Franc. Remember the days when it promised and indeed boasted that its interventions would be “unlimited”. Well it piled in so much it found itself with a problem in the conventional way of hedging this. This is because the scale meant it was distorting Euro area bond markets for example as we mull it competing with the ECB. So its brains trust came up with the idea of buying equities which has turned out to be mostly in the United States.

The equity portfolios in the foreign exchange reserves comprise of shares of mid-cap and large-cap companies in advanced economies and, to a lesser extent, shares of small-cap companies, as well as shares of companies in emerging economies.The SNB does not engage in equity selection; it only invests passively. ( SNB)

You may note that the investment seems guided at first but then switches to pretty much anything. I can however give you a pointer to the US holdings from the SEC data.

As of 2020-09-30, the fund was valued at $127,874,338,000.

With the US market hitting new highs that will have risen since then. Also here are its main holdings there.

According to SNB filings to the end of July, a third of its $125 billion equity portfolio were held in technology stocks. Some 5% of the SNB’s holdings were in Apple shares alone – its single biggest investment – and 18% of its equity stash was in the top five U.S. tech giants.

Something that may get Swiss watchmakers a little hot under the collar is their central bank’s large stake in the producer of the Apple Watch.

Comment

One theme here is the fact that it is the countries I described back in the day as the “Currency Twins” who are at the outer limits of central bank action here. Although there is a nuance in that the SNB is the one explicitly playing the currency game whereas The Tokyo Whale is only playing it implicitly, But there are joint dangers here.

1. Risk of bankruptcy of a share holding. That is fresh in my mind today via the collapse of Arcadia in the UK although as a private company it was different.
2. What do central bankers know about equity market investment?
3. How do they ever stop and one day reverse course?
4. How does this fulfill their mandate?

There are differences as the SNB has the advantage of playing in a much larger market whereas the Bank of Japan is more like Gulliver in Lilliput. How can it exit its own equity market and who would it be able to sell to? As it continues to buy more we get another perspective as it gets ever more unable to retreat.

In conclusion the wider danger is that other central banks get in on the same game as they spot that in relative terms UK and Euro area equity markets have underperformed.