Fixed income in reserves

The era of zero interest rates has come to an end. Since 2021, central banks have been hiking rates to rein in above-target inflation. This has also marked a shift in the effect of monetary policy on reserve management. As many central banks raised their interest rates, bonds became, on the one hand, more appealing as a source of returns. But they also came with the risk of devaluation as inflation persisted. Meanwhile, fixed income returns are also eroded by inflation.

Here, reserve managers discuss with Central Banking how their fixed income asset allocation has changed since 2021, whether they reconfigured their currency distributions and durations, and how they are thinking about the effect of inflation on reserves looking forward.
 

How has inflation behaved in your jurisdiction since 2021? 

Andrés Cabrales, Central Bank of Colombia (CBC): Since 2021, inflation in Colombia has increased because of strong internal and external pressures. Global costs and disruptions in supply chains have led to price increases – and the Russian invasion of Ukraine in 2022 has exacerbated the situation – resulting in higher prices for food and oil. The depreciation of the Colombian peso has driven up internal costs of raw materials and imported goods. Strong economic recovery – particularly in 2021 and 2022, when growth in Colombia was among the highest worldwide – roadblocks and fuel price hikes have also contributed. Automatic price and wage adjustment mechanisms have amplified these effects. Annual inflation steadily rose from mid-2021, reaching 13.3% by March 2023. In the second quarter of 2023, inflation decreased, reaching 11.78% in July because of monetary policy tightening and the adjustment of the economy – but it has remained well above the 3% target. 

Amit Friedman, Bank of Israel (BoI): After years of low inflation in Israel – below the 1–3% target – it returned to the band (2.8%) in 2021. Inflation continued to increase throughout 2022 and peaked in January 2023, when it reached 5.3% – a rate we haven’t experienced since late 2008. In recent months, inflation is moderating; the last print (September) came in at 3.8%, so the fight is not over yet. It is important to note that – although actual inflation breached the target – expected (breakeven) inflation hovered around the upper bar of the inflation targeting band – 3%. This highlights the credibility of the BoI and the inflation tageting regime.

Emilio Rodriguez, Bank of Spain (BoS): Headline inflation in the eurozone peaked at 10.6% in October 2022, initiating a downtrend since then, and reaching 4.3% in September (flash). Despite fuel prices increasing in September, year-on-year energy prices dropped by -4.7%. Core inflation has shown more signs of persistence, hitting its highest level in March this year at 5.7%, but still falling to 4.5% in September (according to preliminary data). Food inflation dropped to 8.8% from 9.7% the previous month. Mid-term inflation expectations have been trading at around 2.6% recently.
 

What factors are driving inflationary trends in your jurisdiction? 

Amit Friedman: As in other jurisdictions, inflation in Israel was driven by some supply-side bottlenecks and a surge in aggregate demand, also due to expansionary monetary and fiscal policies, against the backdrop of a tight labour market. As an open economy, we naturally ‘import’ global inflation – the increase in oil prices, and so on. On top of these usual suspects – which are common to other jurisdictions – an additional factor in Israel is the exchange rate. The USD/ILS depreciated by more than 10% (year-on-year). The exchange rate pass-through to inflation is estimated at 0.1–0.2%, so exchange rate depreciation is a significant driver of inflation today. 

Emilio Rodriguez: The service sector has been the primary driver of domestic price pressures. Rising corporate profits account for a large proportion of the inflation trend in the eurozone, along with import costs – increasing labour costs.
 

What monetary policy decisions has your central bank made in response to inflation? 

Andrés Cabrales: Since 2021, CBC has raised rates to contain inflation and anchor inflation expectations. In the first half of 2023, CBC continued to implement a contractionary monetary policy – with 125 basis points of interest rate increases – due to persistently high inflation above 3%, influenced by supply shocks, slow reduction in core inflation and strong internal demand. The actions aimed to counteract upward price pressures and achieve the 3% target for the end of 2024. Despite a gradual decline in inflation, big challenges remain, including price indexation and the effects of external shocks. Future actions depend on emerging data and uncertainties such as the effects of El Niño. Colombia has high levels of public debt and current account deficits that affect monetary policy decisions. 

Amit Friedman: BoI increased the interest rate, which was very close to the zero lower bound (0.1%) in 10 consecutive Monetary Policy Committee (MPC) meetings to the current rate of 4.75%. Most interest rate hikes in the early phase of the hiking cycle were larger – also known as front-loading. In the last meeting, which took place before the war, the MPC decided to keep the rate unchanged as the assessment was that monetary tightening was sufficient for reducing inflation back to the target.

Emilio Rodriguez: The European Central Bank (ECB) has tightened its monetary policy by increasing interest rates 450bp since mid-2022. As risks to medium-term price stability increased sharply, the eurosystem decided in June 2022 to end net asset purchases under the asset purchase programmes (APPs) as of July, and on June 15, 2023, the ECB’s Governing Council confirmed that reinvestments under the APPs would be discontinued as of July 2023. Isabel Schnabel, a member of the ECB’s executive board, said: “Reducing the size of our balance sheet is warranted for three reasons: first, to regain valuable policy space in an environment in which the current large volume of excess liquidity is not needed for steering short-term market interest rates; second, to mitigate the negative side effects associated with a large central bank balance sheet and footprint in financial markets; and third, to withdraw policy accommodation to support our intended monetary policy stance.” As part of this intention to reduce the balance sheet, the third round of the targeted long-term refinancing operations programme is continuing to fall in 2023 both due to new early repayments and mechanically due to the loan maturities.
 

What effect did inflation and interest rate hikes have on sovereign bonds purchased by your central bank before 2021?  

Andrés Cabrales: Interest rate hikes in advanced economies had a negative effect on CBC’s sovereign bond holdings. Despite our low risk tolerance and relatively short duration because reserves are invested with the objective of avoiding losses with a high degree of certainty, our returns were impacted by the substantial increase in rates from historically low levels. Despite this, it is important to highlight that higher interest rates led to reserve portfolios that earned a higher yield, which compensated and helped overall return. 

Amit Friedman: BoI hasn’t sold bonds purchased under various quantative easing programmes. We still even have long-term bonds purchased during the global financial crisis that began in 2007–08 on our balance sheet. The impact of monetary policy on the value of our local assets is a non-issue.

Jonas Kanapeckas, Bank of Lithuania (BoL): As inflation rose and central banks hiked interest rates, the sovereign bonds in our portfolios unrelated to monetary policy operations suffered marked-to-market losses. However, at the same time, they started accumulating higher yields and providing a cushion against possible further hikes of interest rates. Moreover, during the prolonged period of accommodative monetary policy and declining yields, BoL could add substantially to its financial buffers due to highly positive returns on its bond holdings. Previously accumulated financial buffers allowed us to greatly amortise recent accounting losses.

Emilio Rodriguez: The duration of our portfolios was quite short so the negative impact has been relatively moderate.
 

How have your central bank’s fixed income holdings changed since 2021 in terms of duration, revaluation, buying and selling, and moving into other currencies? 

Andrés Cabrales: During the global tightening cycle, our portfolio maintained a very low duration. Currently, considering prevailing yields and market expectations, we can construct a portfolio with higher expected returns and associated risks. Consequently, duration has been raised recently, and we have increased our allocation in other currencies. The recent performance of the portfolio has been favourable, and the anticipated returns for year-end are relatively promising. 

Jonas Kanapeckas: Regarding duration and trading policies, BoL did not change its investment and asset allocation framework because of recent devaluation of its bond holdings. We continued efforts to diversify our portfolios by adding new asset classes and currencies, and focusing on medium-horizon expected returns and risks. We also put additional effort into comprehensive communication on interpreting our recent performance, strategies employed, goals we pursue and the horizons we focus on.

Amit Friedman: After holding a relatively short fixed income portfolio in 2021 – with an average duration of two years – BoI started to extend duration gradually in 2022. The duration of the US dollar portfolio was 2.3 years, and the euro portfolio was shorter, 1.5 years. We started 2023 with duration of 2.5 years in the US dollar portfolio and, in July 2023, the duration was extended to three years.

In addition, our currency benchmark has significantly changed. Previously, it included only three currencies: US dollars, euros and sterling (the breakdown was around 67%/30%/3%, respectively). In early 2022 we moved to a broad currency benchmark that includes seven currencies. The US dollar and euro weights were reduced to 61% and 20 %, respectively, the sterling weight increased to 5%, and four new currencies – Japanese yen, Australian and Canadian dollars, and Chinese renminbi – were added (with the respective weights 5%/3.5%/3.5%/2%). The purpose of the increase in diversification was to better match new foreign exchange reserves investment guidelines, which require measuring return not only in numéraire terms but also in local currency.

Emilio Rodriguez: BoS has made no material changes to its currency composition. Recently, we have gradually increased the average duration.
 

Have additional gold purchases come at the expense of additional asset classes?  

Andrés Cabrales: Gold allocation has not increased in CBC’s case. 

Jonas Kanapeckas: BoL kept the amount of gold it holds unchanged for a very long time – measured in decades. If we reconsider our approach to gold holdings, we would determine our optimal size of the gold position in the whole portfolio context, not in isolation with a subset of asset classes – in effect, evaluating its impact on a general level of diversification, risk and return characteristics over appropriate horizons.

Emilio Rodriguez: BoS’s gold holdings have undergone no change in recent years.

Amit Friedman: BoI has not held gold since the early 1990s.
 

How are the inflation and interest rate decisions (of your central bank and others) driving your investment decisions in assets other than sovereign bonds?  

Andrés Cabrales: We continue to analyse new asset classes (and increase allocations in others) to enhance diversification and achieve improved risk/return metrics. For instance, interest rate policies are influencing significant decisions even within fixed income, as monetary policy cycles may be synchronised in certain countries, while others – particularly in Asia – might follow a distinct trajectory, providing diversification advantages, even in sovereign bonds. Furthermore, we have observed that other asset classes could benefit if markets perform as anticipated, enabling us to position portfolios for better expected returns. New asset classes may act as diversifiers for fixed income instruments, generating comprehensive
diversification benefits. 

Jonas Kanapeckas: Decisions to include additional assets in our investment portfolio are influenced mainly by their impact on portfolio diversification, medium-horizon expected returns and inherent active management possibilities. At the same time, we tend to hold a more significant investment portfolio in times of high inflation and interest rates, and vice versa in times of accommodative monetary policy stances and low
interest rates. However, it is not sufficient to go for longer bonds and a larger portfolio when interest rates are higher – we must be aware that by this, we expose ourselves to the risk of missing the point when we experience rate hikes from low levels again. In other words, if we justify asset allocation decisions based on the general level of yields, we can appropriately evaluate our strategy only after an entire economic cycle.

Amit Friedman: Our main asset class other than fixed income is equities. We increased our allocation of equities for a decade to 20% in 2022 – which is very high in the reserve management business. This move was motivated by our view on the optimal long-run allocation, but also because we realised that, in an inflationary world, equities provide a hedge while fixed income nominal assets do not. We increased the allocation to equities even after years in which equities had a negative return. We also started to invest in high-yield bonds in 2022, and allocated 2% of our portfolio to this asset class.

Emilio Rodriguez: There has been no relevant impact because our main exposures continue to be on government and quasi-government bonds.
 

How are the monetary policy decisions of your and other central banks affecting the duration and currency composition of sovereign bonds you are investing in or considering investing in?   

Andrés Cabrales: Given current yield levels and market expectations, we have cautiously increased duration (from very low levels) to increase expected returns. 

Jonas Kanapeckas: As globally higher interest rates make longer-dated bonds and a broader set of currencies attractive for reserve managers, we use this opportunity to diversify our portfolio further. However, at a strategic level, we focus more on longer-term, more stable portfolio risk/return factors and general diversification goals, limiting our exposure to interest rate timing risk.

Emilio Rodriguez: As a central bank within the eurosystem, we have not undertaken any active management of the euro-denominated portfolios so as not to interfere with the objectives and implementation of monetary policy portfolios. However, the distribution of reserves by currency follows a strategic distribution that takes into account other factors beyond monetary policy decisions, including credit, feasibility and sustainability considerations, among others.

Amit Friedman: Generally, we think the approach for this issue is to take limited positions based on expected monetary policy versus a ‘natural’ duration anchor. However, the question of the natural duration level is something we plan to reassess in the near future.
 

Do you expect inflation and interest rates to normalise in your jurisdiction in the next 12 months?  

Andrés Cabrales: The cumulative effects of monetary policy – along with decreasing external and internal supply shocks – are expected to guide inflation towards the target rate. Throughout 2023, international prices and costs are projected to decrease, supported by a lower exchange rate and a strong supply of perishable foods, which will help alleviate cost pressures. The focus of monetary policy will continue to be on reducing excess demand and promoting sustainable production levels. Despite fuel price increases, consumer inflation is expected to decrease, with the aim of converging to the target by late 2024. Market expectations are aligned, and current policy rates are expected to be lowered during H2 2023. However, Colombia’s twin deficits remain a factor and are an important consideration for our interest rate risk premia. 

Emilio Rodriguez: Inflation continues to decline, but is still expected to remain high over the next 12 months. The ECB’s macroeconomic projections published at the governing council meeting on September 14 see average inflation at 5.6% for 2023, 3.2% for 2024 and 2.1% for 2025 – which is still slightly above the 2% inflation target. The forecasts for 2023 and 2024 were revised slightly upwards from the June projections (by 0.2%) because of higher energy prices. Core inflation is expected to average 5.1% in 2023, 2.9% in 2024 and 2.2% in 2025.

Higher energy prices are moderating the deceleration trend of headline inflation; food price inflation has come down from its peak in March, but remains high, while base effects will have a positive impact on inflation figures in the coming months. The annual growth rate of compensation per employee remained constant at 5.5% in Q2 of the year. Most measures of underlying inflation are starting to fall as demand and supply are more aligned and the contribution of past energy price increases fades out, but domestic price pressures remain strong.

Upside risks to inflation include potential renewed upward pressure on energy and food costs. On food prices, adverse weather or climate change risks could push prices up by more than expected. Additionally, a lasting rise in inflation expectations above the target (longer-term expectations currently stand at around 2%), higher wages or profit margins could push inflation higher over the medium term. Downside risk to inflation could be driven by weaker domestic or international demand, because of the worsening of the economic environment.