Central banks still value diversification, say reserve managers

The sharp increase in US sovereign debt yields in the past few months is unlikely to result in central bankers ending their decade-long pursuit of foreign exchange diversification, according to delegates attending National Asset and Liability Management Americas 2018.

Central banks have sought alternatives to US dollar sovereign assets by investing in a greater range of reserve-currency sovereign debt, agency-backed and corporate debt, equities and other instruments.

This was partly the result of falling yields from investments in US Treasuries as the Federal Reserve pursued extraordinarily loose monetary policy, in the aftermath of the global financial crisis. The compression of yields caused a problem for central banks that fund their operations from reserves incomes and was a particular issue for central banks that are reluctant to request additional funds from their governments.

Minutes from the Federal Open Market Committee in May indicate the Fed might raise rates two more times this year and two or three times in 2019 – meaning the Fed funds rate should hit 3% by the end of next year. This makes investing in US sovereign assets attractive (although it can hit the relative value of existing holdings) – something that could be further exacerbated if the US central bank has to raise rates faster than expected due to tax cuts in the US causing the economy to run ‘hot’. 

One central bank risk manager attending the event in Santiago on May 24 and 25 said the current situation made floating rate notes attractive as a good way to gain exposure. These pay varying amounts of interest based on discount rates in auctions of 13-week Treasury bills quarterly until maturity. “Because the hiking cycle is not over yet, floating rate notes take advantage of additional coupons, without increasing duration just yet,” the official said.

However, reserve managers and risk managers attending the Chatham House rule Central Banking event in Chile, said no amount of US rate increases would undo the value of diversifying holdings in other currencies and asset types. This was mainly due to risk and liquidity factors.

Liquidity, liquidity, liquidity

For example, one central bank with a diverse reserves portfolio has conducted research on how quickly it could liquidate its portfolios. Perhaps surprisingly, it found its US Treasury holdings – admittedly the largest segment of its portfolio – would take the second longest time period to sell under typical market conditions. This raised the question about whether too large a concentration of US sovereign debt may be sub-optimal.

“Every asset has its own stress scenario,” said one central banker. “We have seen that with US Treasuries. When there were talks about the debt ceiling being breached, that caused a stressed event for particular US Treasury securities, although not all of them.”

The question of US Treasury liquidity was an area a number of reserve managers believe requires more study, particularly how such a draw-down would work during stressed markets conditions.

But a reserve manager at one of the region’s smaller central banks said given the relatively small size of its forex assets, his central bank would face no liquidity issues should it sell its US Treasury holdings, but it is important to establish which instruments within a benchmark “have the best spreads and are most liquid when replicating the index”.

Another central banker said there is a need to carefully map out liquidity profiles and it may not make sense to sell the most liquid forex assets as a crisis starts. “Selling some of the more illiquid assets ensures there are still highly liquid assets left in the portfolio should conditions deteriorate further,” the official said.

Having the ability to sell a range of assets may also be useful for central banks when they want to intervene without disclosing their activities to the market. And the benefits may also hold true in a more distressed scenario. “If we ever need to make a larger intervention – it will be helpful to use different assets,” said one central banker.

Changing risk profile

There is also a perception that the ‘safety’ of US sovereign debt, which has lost its triple-A rating, is not as strong as it was prior to the global financial crisis. And new US tax cuts being introduced by the administration of US president Donald Trump have raised further concerns about fiscal sustainability in the US.

This could support further diversification.

But a risk manager from a G-20 central bank said the US “was not alone” on this “downgrading trend”. “A lot of European countries were also downgraded,” the official said. “In terms of risk, yes it has gone up since 2008. But it has gone up across the board and there is nowhere to go.”

Euro, yen and sterling?

There are other problems associated with investments in viable alternative currencies to the US dollar.

The rise of a populist government in Italy has renewed fears about the viability of the euro for the first time in years. Meanwhile, large purchases of Japanese government bonds by the Bank of Japan are a concerning distortion for some. “Can you really be a reserve currency when everything is held by the central bank?” asked one central bank risk manager.

One risk manager from a central bank with large forex reserves said there are tactical opportunities to make euro and yen bets, although this official’s trades are being done on a fully hedged basis.

Sterling volatility has also made some sovereign investors wary of the UK debt. “We are seriously evaluating whether we should lower our levels due to interest rate spreads and a big depreciation – about a 10-point drop,” said one portfolio manager.

“We do look at the volatility of other currencies when adding them,” said another central banker, “so we try to build in a buffer.”

Assets and liabilities

Typically reserve managers pursue three key objectives when making forex investments: safety, liquidity and return – in that order.

Another important component of holding reserves is the ability to use forex assets to cover national liabilities, such as debt issued in foreign currency or payments for imports.

As a result, currencies such as the renminbi have emerged as alternative investments to typical US dollar, euro, yen, sterling and Swiss franc investments.

“We do not have reserves in renminbi,” says one central banker. “But from a long-term perspective, [given] the shifting global tides and increasing role of China, and for liquidity and capital preservation purposes, it makes sense for many countries to be raising their investments in renminbi.”

A representative from a central bank that does hold renminbi said the investments were “good in terms of diversification”, but was “not sure” they had “provided a lot of yield” as the central bank did “not have a very large investment”. “We will probably continue to increase our holdings if China keeps trying to open its markets and give additional security to investors as it has been doing,” the official said.

The same official added that the renminbi is already the most traded emerging market currency and Chinese bonds are due to join the Bloomberg Barclays Global Aggregate Index from April next year.

Another reserve manager warned central bankers to be wary of using Australian dollar investments as a liquid proxy for managing Chinese liabilities. The reserve manager said China’s efforts to focus on upscale manufacturing, services and consumption could delink commodities demand, which bolsters Australian assets, from Chinese growth moving forwards.