Central banks do not play games with the markets but it sure feels like we are being played by someone! Earlier this year the Bank of Japan, Federal Reserve and the European Central Bank all had similar balance sheets at around $4.5 trillion. As we know, over the past ten years all three have risen from lower levels but have seen faster expansion by the BOJ and the FED gaining pace to now catch the ECB. Foreign exchange rates are always subjected to inherent volatility that is thrown into the mix. However, given the recent extremes on all fronts, there has been uncanny similarity around end of Q1’ 2017.
Typically, a central bank balance sheet would off-set Assets against Liabilities and capital.
On the assets side would sit: –
(i) Net domestic assets, and
(ii) Foreign assets.
Liabilities would list: –
(ii) Non-monetary liabilities (Central bank securities and other), and finally
(iii) Equity Capital
(iv) Reserve money (currency in circulation and those of commercial banks)
In times of crisis it is common the central bank assumes the role of lender of last resort. Assuming the crisis was 2007/8, then it should be normal to expect the balance sheet to now shrink back to the levels of the pre-crisis era. However, we have heard many comments recently from the FED about re-normalizing their balance sheet but the BOJ and ECB are set to carrying-on for the foreseeable future
Focusing now on the first two, BOJ and FED, the process is so much simpler because much of the debt is consolidated and displays a meaningful explanation of their economies. The heavyweight here is the BOJ with assets held close to 100% of GDP but the risk here could be off-set by the currency. Japanese debt is held domestically because of the currency controls. Hence, the yen could collapse to devalue the debt fairly easily once the markets wake up and smell the roses. The FED never came close to absorbing the full national debt or a percentage of GDP as has taken place in Japan or Europe.
Turning to Europe, the equation becomes far more complex when you consider the case for the European Central Bank. Since they initiated the APP (Asset Purchasing Programme) we have seen a need to follow cash within the components of the ECB itself. Within the European structure each central bank buys their own debt in relation to the size of their economy. The guidelines covering this activity are entitled Target2 and are easily found on the ECB website. What should be monitored closely is the trading between sovereigns, the rates at which all are traded, who the counterparties are (where they are located both domestic and international), and FX forwards’ trades that match the transaction dates. In many cases the NIM (Net Interest Margin) for many banks looks terrible but that is because the profit will appear in the FX books (which is the other side of the trade). Many reasons for the discrepancies’ from following the cash to liabilities, but Target2 and the concerns surrounding this are only recently starting to make some take a closer look.
Much has been published about Target2; so, let us concentrate on the fact that both Spain and Italy owe Germany around $400bn each. Neither the BOJ nor the Federal Reserve have this problem (internal macro issues) so from this angle alone there should counterparty risk that must be factored in. However, as we know the 10yr Bund (0.45%) trades around 185bp through treasuries (2.30%) and even Spain and Italy are negative 70bp (1.6%) and negative 20bp (2.10%) respectively. In short, we are seeing Spanish and Italian domestic investors moving away from government bonds thereby aiding capital outflow. This is fine for individuals and Spain/Italy but is just moving the risk up the food chain.
As we know the ECB owns around 40% of the European government bond market as we currently stand. Obviously, at these spreads the market is hardly reflecting appropriate risk and questions the likelihood of any easing without having a huge implication on both spreads and risk. The question should also move to counterparty risk for not just Germany but ultimately the ECB! Maybe they should read their own recently published report (ECB guide on materiality assessment – 25th September 2017) as they increase the awareness of counterparty risk and the Credit Valuations Adjustment, they are not applying that to themselves.
QE has broken the capital markets, distorted risk and has sheltered geographies from the true effects of capitalism. If the central banks were playing poker you could say the ECB has just gone “All In” – its just a question now whether the markets call their bluff or fold.
What we are looking at is the risk of actually central bank defaults. This has not taken place since the defaults of government central banks in Amsterdam and Sweden.
....also from Martin:
...also don't miss the full interview with Michael Campbell Sept. 30th.