A Pivotal Problem for Central Banks

A Pivotal Problem for Central Banks

We have commented in previous notes about the understated importance of the trend in bond yields in the post-2008 environment for asset prices and monetary policy alike. Lower highs and lower lows in official interest rates were effective tailwinds as rates and bond yields gravitated towards zero. Or in the case of bond yields, through zero. It was only a few years ago that around USD $19 trillion of government bonds had negative yields (that figure today is slightly higher than USD $2 trillion).

Even in instances where central banks sought to withdraw stimulus and reverse lower-than-trend interest rates, they did so in the knowledge that they had sufficient capacity to lower interest rates further, should asset market volatility not be to their liking.

The ability of central banks to pivot came in the main through the aegis of a benign inflationary environment. It seems surreal now that central banks’ failed attempts for years to feather inflation higher came to its conclusion in such a dramatic way in late 2021.

As a result of the re-emergence of inflation since Covid-19, central banking has become significantly more difficult. Previous attempts to withdraw such stimuli caused havoc in financial markets, meaning that the full withdrawal of post-2009 stimuli was a long way from being achieved prior to Covid, and fiscal and monetary responses to the pandemic dwarfed those between 2009 and 2019.

In essence, the current move towards normalizing fiscal and monetary policy means reversing actions that were deemed too difficult to remove previously.

So, how much more difficult is central banking today?

Before considering the rapid growth in inflation around the world, especially in food and energy, the chart below records the magnitude of the growth in central bank balance sheets. This chart represents the “G5”, which is the collective central banks of the United States, Europe, Japan, the United Kingdom and Canada. While these balance sheets have many, many derivatives in them, let’s assume it is a bond portfolio:

In mid-2007, the combined size of these balance sheets was USD $3.4 trillion, and held various interest rate securities, from government bonds to corporate credit to mortgage-backed securities. By February of this year, as inflation unambiguously lurched higher, the size of these collective balance sheets increased to an eye-watering USD $26.7 trillion. With policy rates and bond yields in particular having risen in response, this number has since declined by USD $1.5 trillion.

Most of this reduction has occurred due to unrealized losses on central bank interest rate assets.

Consider the next chart below, which maps the severity of the selloff in government bonds this year, so far the worst returns on record:

For illustrative purposes, the chart tracks the movement of ten-year bond yields in Italy, Germany, Switzerland, the United Kingdom, the United States and Australia.

The table below records the post-Covid lows in those yields, as well as the current yields at the time of writing. The far right column records the percentage price decline in such ten-year bonds:

The capital price destruction in the space of barely a year is extraordinary. While such balance sheets consist of many more securities than such long duration bonds, there is also considerable credit risk in non-government exposures, and credit spreads are also sharply rising around the world as interest rates increase.

We have commented before on the vastly deteriorating credit quality across various debt markets. At one point, almost a third of Russell 3000 index could not service interest costs from revenue. Such “zombie companies” could exist under a regime of very low rates but now the game has changed.

It is likely that lowly rated companies will default as their cost of funds greatly increases.

Various corporate bonds on central bank balance sheets will also contain unrealized losses as interest rates increase, and there is a greater risk of some permanent loss of capital in the event of default. And with some countries’ finances in a parlous state (witness Sri Lanka), such rising default risk could manifest in government bond markets as well as corporate credit markets.

As an exercise, let’s assume that the interest rate duration exposure of the G5 is half that of a 10 year bond. It is most likely less than that, but all corporate credit risk would effectively add to duration risk. Using a broad average of the above price declines (say -25%) and halving that (-12.5%), such unrealized losses on the G5 balance sheets would currently be approximately USD $3.3 trillion, which is almost the exact same size as the UK economy (the sixth-largest in the world).

Note, this does not allow for precision in terms of the timing of such purchases – it is merely to explore the potential quantum of unrealized losses.

It would be impossible to predict the potential magnitude of any defaults of G5 debt holdings, but suffice to say rising inflation, coupled with higher interest rates and the potential for a massive reversal from passive investment to passive disinvestment, will place enormous strain on the valuations of such holdings.

So, what does this mean?

Central banks ostensibly have two choices, neither of them good. They can either (i) adopt policy that effectively lags inflation, or (ii) adopt policy that arrests inflation.

But in reality, they only have one choice.

If they were to lag inflation, bond markets around the world will continue to sell off. This would feed into asset markets, just as it has all year so far, which would further erode valuations on central bank balance sheets. Further, any hint of central banks “pivoting” on their stimulus withdrawal too early will add to inflationary expectations, which if they become anchored, is a huge problem.

The only choice they have is to be aggressive in fighting inflation. As a result, asset prices may fall further, thus eroding the valuations of these assets on central bank balance sheets. It is a good thing most central banks only have a relatively small trading book, where fixed interest assets are marked to market and other fixed interest assets are valued on a hold to maturity basis.

That said, it was somewhat of a shock to see the Swiss National Bank holding US equities on its balance sheet, so price discovery there has been rapid and savage. Time will tell if a derivative shock might have a similar impact on other central bank balance sheets.