Quick presentation on major central banks' challenges and next steps

Attached presentation provides a quick overview of some post-cricis actions and challenges faced by the three major central banks: the BOJ, the Fed, and the ECB.


Central banks in the post-crisis world

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DE central banks' balance sheets approaching $6 trillion; expected to grow another $1 trillion in 2013

This is a well covered subject, but it's worth taking a quick look at the combined balance sheets of the developed economies' (DE) central banks. We are quickly approaching six trillion dollars.

Source: ISI group

It is important to note that not all of this would qualify as "QE". For example the Fed expanded balance sheet in 2012 without materially impacting either the bank reserves or the monetary base (see discussion). Although it was unintentional, the Fed effectively "sterilized" its purchases. The ECB also views some of its programs as sterilized.

Nevertheless it is expected that the developed nations' central banks will expand their balance sheets by another 1 trillion dollars in 2013. This will be driven mostly by the Fed and the BOJ (see discussion). And unlike last year, the US monetary base will grow sharply in 2013 (and so will Japan's). Central banks continue to feed the markets' addiction to stimulus (see discussion).

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Markets' addiction to central bank stimulus dominates financial headlines

Financial markets' addiction to central bank stimulus is out of control (see previous post). Below are some financial media headlines from the last few days discussing market moves - in no particular order. The news driving markets now constantly originates from central banks (or related government entities) - with earnings mixed in here and there. Central banks' actions (or inaction) are often the major factors in securities valuation. What is not clear however is if market participants and the public understand that this is not how financial markets have typically operated in the past (even though central bank actions were always a component of valuations) and is not how free markets should operate.

We go from this one day:

Reuters: - U.S. stocks rose modestly on Tuesday on investor confidence that Federal Reserve stimulus would underpin equities and purchases by money managers wanting to touch up portfolios before the quarter's end.

... to this the following day:

WSJ: - The Standard & Poor's 500-stock index dropped nine points, or 0.6%, to 1447. The Nasdaq Composite fell 29 points, or 0.9%, to 3131.

Federal Reserve Bank of Philadelphia President Charles Plosser said the U.S. central bank's new mortgage bond-buying program is unlikely to boost growth, and that the effort could harm the Fed's credibility.

"There are many investors who think the Federal Reserve was the catalyst for this latest move," said Michael Shea, managing partner with Direct Access Partners. "If you have another Fed governor dissenting with what the Fed's doing, you're going to spook some people."

And it just keeps going.

PBoC:

Reuters: - Mining stocks .SXPP rose 1.2 percent after China's central bank injected cash into its money markets and traders speculated it may also take steps to boost the country's weak stock market, to arrest a slowdown in its economic growth.

ECB:

Reuters: - Global investors staged a tentative return to euro zone stocks and bonds this month following the European Central Bank's bond-buying rescue plan and credit easing from the U.S. and Japanese central banks, a Reuters poll showed on Thursday.

BoE:

Reuters: - Traders said talk of new central bank stimulus measures from the likes of China or the Bank of England was preventing equity markets from sliding 

BOJ:

WSJ: - European stocks rose and the euro nudged up against the dollar Wednesday, after the Bank of Japan jumped on the stimulus bandwagon by announcing an expansion of its asset-purchase program.

The BOJ said it will increase it asset purchases to 80 trillion yen ($1.01 trillion) from Y70 trillion, just one week after the U.S. Federal Reserve announced another round of quantitative easing.

RBI:

The Hindu: - After surging 250 points in anticipation of a rate cut, the Sensex on Monday closed only 78 points higher - registering 9th straight day of gains - as investors were not excited at RBI just reducing CRR by 0.25 per cent and keeping key interest rates unchanged.

And it's not just about the equity markets:

SF Gate: - The yuan climbed to its strongest level since 1993 on speculation China will step up efforts to arrest a seven-quarter slowdown in the world’s second-largest economy.

Of course like any drug, the high wears off quickly.

Bloomberg: - Asian stocks fell amid concern stimulus measures by central banks won’t be enough to boost global economic growth ...

Investors are “finally realizing that recently announced liquidity injections from central banks will do nothing to address the structural issues,” said Matthew Sherwood, Sydney- based head of markets research at Perpetual Investments, which manages about $25 billion.

Until the next fix...

TheStreet.com: - The U.S. equity market next week will start the final quarter of 2012 with a heavy schedule of reports highlighting conditions in the U.S. economy, with all leading up to figures that will show if there’s been any improvement in the shaky labor market.

The action starts Monday with Federal Reserve Chairman Ben Bernanke slated to deliver a speech on monetary policy.

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Central bank policy driving corporate spreads

People sometimes wonder why US credit managers spend so much time analyzing the monetary policy actions (or potential actions) of major central banks. Barclays Capital put the answer to this question on a single chart. The chart shows investment grade CDX (index of corporate investment grade CDS) spread in relation to the major policy decisions of the ECB and the Fed.

IG CDX spread

The start and end of each major accommodation tends to be near the inflection point in the credit markets. Clearly there are other factors involved in moving investment grade corporate spreads. But the bulk of these trends could potentially be explained by central banks' policy alone.

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Keeping the world from double dip: cheap euros - come and get them

When it comes down to it, the central banks will find a way to keep the financial system afloat and economies from slipping into recession. As we saw this morning, the news from Draghi (ECB) is: we have tons of cheap euros - come and get it.

• 25 bp rate drop 
• Ease collateral criteria for loans to banks
• 3-year loans to banks (even the Fed didn't provide direct 3-year loans to banks in 08)

The general statement was "the ECB adopts non-standard measures to aid banks".

With that in mind, it makes sense that Barclays does not see a global double dip recession.  They definitely see a slowdown in the "developed" nations, but no negative GDP.  Their view is that emerging markets will continue on the current growth path.

Given the sovereign crisis and a slowdown in emerging markets, the only way one can come to grips with this forecast is through conviction that central banks globally will continue to be extremely accommodating. The chart below shows the growth trends in central banks' balance sheets.

Having said this, significant risks remain that EU leaders will make such a mess out of the euro-zone crisis, that even the central banks' accommodating policies may not be enough.

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The not so "secret" ECB lending efforts

With the all the hoopla about the "secret" loans to US banks during the 08 crisis, there doesn't seem to be the same level of scrutiny on the ECB's current support for European banks. In dollar terms the amount outstanding to European institutions is over 3/4 of a trillion and growing. This shows increasing dependence of European institutions on the central bank for short-term funding. The ECB is also considering easing collateral requirements (as banks run out of eligible collateral) as well as adding 2-year loans to allow banks to lock in term funding.

ECB lending to Euro-area banks in Billion EUR (Bloomberg)

There are other forms of support from the ECB.  To add liquidity to the systems the ECB continues to purchase covered bonds as part of their second "mini-QE" program.  The idea behind covered  bonds is to supposedly avoid taking on sovereign risk directly.

 ECB Covered Bond Purchase Program # 2 (source: ECB)

To address European banks' continuing need for dollars the ECB keeps tapping the Fed's Liquidity Swap Facility (chart below).

These efforts from the central banks, combined with the Fed's move to cut dollar borrowing costs on this facility, has reduced the EUR/USD Currency Basis Swap spread quite dramatically.

3-month EUR/USD Basis Swap Spread (Bloomberg)

But tightness in term dollar interbank funding continues to persist with USD LIBOR grinding higher.  This is particularly noticeable in the 3-month TED spread (LIBOR to T-bills):

3m TED Spread (Bloomberg)

Based on this, one should fully expect to see the ECB do more (not so "secret") lending and continuing to come up with innovative ways to keep the euro-zone banking system afloat.

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The European bank failure hype from Forbes

Nigam Arora, a contributor to Forbes Online, wrote the following today: 

Forbes: It appears that a big European bank got close to failure last night. European banks, especially French banks, rely heavily on funding in the wholesale money markets. It appears that a major bank was having difficulty funding its immediate liquidity needs.

"It appears" Mr. Arora?  This certainly started a buzz in the market.  Arora continues: "The cavalry was called in and has come to the successful rescue."

And where exactly are you hearing about this supposed bank failure?  Maybe you can tell us how a 50 bp reduction in dollar borrowing rate would have averted a European bank failure?

Just because you are an engineer and a nuclear physicist, are we supposed to take your word for it? Absolutely no evidence of such an event has been provided in the article.  So congratulations Mr. Arora.  You get the Sober Look Hype Award.

We are doing well with the Hype Awards - two already this week, and that doesn't even count the La Stampa fiasco.

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Central bank foreign reserves currency allocations - a shift away from USD

As the dollar continues to get clobbered (chart below), it is helpful to see what central banks are doing with their reserves. This is particularly useful because central banks don't trade currencies (at least they are not supposed to), and the allocations are often indications of longer term policies/trends.



source: Bloomberg


A recent release from IMF shows the following allocation picture as of the end of Q2 (this is on a quarter lag, but still useful):



source: IMF


And here is the Q1 to Q2 change in the amounts allocated to each currency (shown as percent change from the Q1 allocation amounts). Note that the Swiss Frank (already a small allocation) continues to drift down as central banks begin to see Switzerland as too leveraged to it's financial services industry.



source: IMF


Looks like some allocation to the USD continued in Q2, but allocations to EUR, JPY, and other currencies have increased much more. That makes USD a smaller percentage of the overall foreign reserves. In fact the USD percentage has dropped to a record low of just under 63%. And that is looking more like a trend.

source: Bloomberg


If the trend continues, it will become particularly difficult for export focused nations such as Japan and Germany. Given the size of foreign reserves (foreign exchange holdings are now at $6.8 trillion), even small reallocations to EUR and JPY will cause sizeable currency appreciation.