Beaten at Their Own Game - Central Bank Investments Hurt by Inflation and Rising Rates.
5 major trends to remember from the beginning of 2022.
Central banks do not just decide on the direction of monetary policy. They also have to manage reserves, mainly in the form of bond and money market assets. These two activities are independent so managers do not know the decisions on rates before they are made public.
It is therefore inevitable that central banks, such as the Fed or the ECB, suffer the consequences of their own interest rate decisions. This is currently the case. Like all bond managers, they have accumulated low or even negative-yielding assets in their portfolios, and with the rise in interest rates, they are now accumulating capital losses (bond prices and yields are moving in the opposite direction).
Rising inflation and future monetary tightening are also at the top of their concerns, according to an annual survey by HSBC. In February-March 2022, the bank surveyed 82 central banks managing $7.3 trillion in reserves, half of them worldwide. Central banks have long considered inflation to be a transitory phenomenon. In recent months, they have realized that they acted too late and too weakly against rising prices and have continued to tighten their rhetoric. However, there is still a feeling that the Fed and the ECB are not yet really taking the inflationary risk seriously.
What are the other main findings of this HSBC study?
1. Limited currency diversification
For three-quarters of the managers of European institutions, the main risk is geopolitical: it is linked to the war in Ukraine. Only one central bank out of 82 plans to invest in the ruble in the next five to ten years and none is currently invested in it. On the other hand, the renminbi is becoming a must. One institution out of two has invested part of its reserves in Chinese currency (government bonds and increasingly bank debt) and more than a quarter want to invest in it.
The IMF made no mistake in strengthening the renminbi recently in its special drawing rights:
2. Massive exposure to government debt
The vast majority of central bank reserves are still massively exposed to debt, especially government debt, and 80% of them are invested in bonds with maturities of less than three years. In addition to these liquid assets, they invest around 8% of their reserves in more or less risky diversification assets (emerging debt, corporate and asset-backed bonds, etc.).
Among them, inflation-linked bonds are particularly popular in the current context. 42% of central banks already hold them and 16% will soon follow their example. In a still marginal way, they are considering investments in real estate and infrastructure, which also have the advantage of offering protection against rising prices.
“Central banks will continue to diversify their reserves over the next two years, and rising rates will not hinder this long-term trend,” said Nick Carver of the Central Banking Institute and author of the study. “The past two decades of low or even negative rates had encouraged them to increase their range of asset classes, markets, and products to improve their investment returns”.
3. The weight of history is no longer enough for gold
Today, more than two-thirds of central banks invest in gold. But its performance is not sufficient for them to consider increasing their exposure. Many central banks cite the weight of history and inertia. When currencies were backed by gold, they had to hold a significant amount to ensure convertibility and reassure the markets. But since 1971, this period is over.
4. Switzerland is the champion of equity investment
31% of central banks invest in the stock market. Leading the way is the Swiss National Bank (SNB), with 23% of its investments in equities, particularly American ones. The SNB is itself listed on the stock market (+12% in 2021). However, the poor performance of the stock markets this year could give pause to those in favor of such diversification.
5. Caution on alternative investments
One central bank has taken the plunge and invested in digital and crypto-assets. More than one in four central banks do not rule out following this example, but in the medium term, i.e. not for another five years. Central banks are known to be rather cautious in their investments and want to wait for all the regulatory clarifications before investing even a very small part of their reserves in these volatile crypto assets. One central bank has invested in a hedge fund, but only a minority (5%) is considering such a risky investment in the coming years.
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