BBVA held in March its 6th annual Public Sector Investors and Issuers Seminar bringing together 60 central banks, sovereign borrowers, supranational institutions, and national agencies for 3-days of discussions on a broad range of investment themes.
Some of the key themes discussed were the impact of unconventional monetary policies on public sector issuers and investors, the challenges facing reserve managers in times of negative interest rates, and the debt management strategies of public sector issuers. The following are four of the most interesting issued discussed.
Monetary policy normalisation in the US and Europe
The BBVA Seminar discussions took place against the backdrop of an improving world economic outlook and the receding threat of deflation in the US and Europe. Not surprisingly, one of the most commented themes was the unwinding or “normalisation” of unconventional monetary policies by the US Federal Reserve (FED) and the European Central Bank (ECB), and its likely impact on issuers and investors.
The FED is further down the road of monetary policy normalisation having decided in 2014 to limit asset purchases under its Quantitative Easing (QE) program to the reinvestment of principal payments on its bond portfolio. This important measure has been followed by three 25 basic points rate rises to the benchmark federal funds rate since December 2015.
The market is now watching closely the FED’s next moves in terms of further rate increases (current market consensus of two more rate rises in 2017) and the gradual reduction of its balance sheet which has quadrupled to 4,5 trillion dollars as a result of asset purchases under the QE program. The FED is arguably setting the template on monetary policy normalisation for other central banks to follow which would comprise three sequential steps: firstly a reduction of asset purchases followed by rate increases and lastly balance sheet reduction.
By comparison, the ECB is at a much earlier stage of normalisation, having just recently lowered the pace of monthly asset purchases under its Public Sector Purchase Program (PSPP) from 80 billion euros to 60 billion for the remainder of the year. In its most recent policy meeting this past March, the ECB did not modify its forward guidance on interest rates and maintained its commitment to a deposit rate of minus 0.4%.
Impact of the ECB’s QE on euro issuers…
The ECB’s QE programme has been clearly supportive for Eurozone sovereign, agency and corporate issuers whose debt is eligible under the various asset purchase programmes.
The ECB’s announcement this past March that it was reducing the monthly volume of asset purchases under the PSPP, and the uncertainty surrounding the programme’s continuation post 2017, led to a rise in sovereign yields, particularly for countries such as Portugal, Italy and Spain, with higher debt levels and potentially more exposed to higher borrowing costs once monetary policy is less accommodative.
Not surprisingly, partly in anticipation of the ECB’s lower asset purchases and rising yields, the issuance volumes in Euros for the first three months of this year reached 365 billion euros representing a 135% increase versus the first quarter of 2016.
…and on public sector investors
The unconventional monetary policies have also had a significant impact on the investment strategies of public sector investors, such as central banks and sovereign funds.
The spread of negative rates amongst reserves currencies such as the euro and Yen is leading many central banks to revise their Foreign Exchange (FX) reserves management strategies and revaluate their core investment principles of S-L-R: prioritizing security (capital preservation), followed by liquidity (liquidity provision) and then return (income generation).
Many central banks are thus targeting higher yields without renouncing the core principle of capital preservation. In order to do so, they are re-examining risk tolerance levels, extending investment horizons, and considering greater diversification across and within asset classes. The immediate consequences of this revised approach have been lower allocations to the euro, extended duration in search for yield, increased exposure to credit risk and broader asset diversification, with investments in corporate bonds and even equities.
Perspectives for the euro as a reserve currency
Finally, another interesting development noted during the BBVA Seminar is the euro’s gradual fall as a central bank reserve currency since the start of the financial crisis (from 26% share of total FX reserves in 2007 to less than 20% in 2016). Over this period the US dollar had held fairly steady at 62-64% of global FX reserves, with the euro’s decline offset mainly by higher central bank holdings in the Canadian dollar, Australian dollar, Chinese Yuan and Japanese Yen.
It will be interesting to see if the euro is able to regain its pre-crisis footing as a reserve currency once monetary policies in the US and Eurozone converge and the Eurozone finally lays to rest, through further political and economic integration, any lingering risk of a breakup of the euro.