Commentary:
One of the most interesting and unprecedented decisions the ECB has made recently was not to conduct QE, but rather to cut interest rates into negative territory. While it is true that other countries have experimented with negative rates prior to the ECB, the ECB’s decision to apply a negative interest rate to the second largest reserve currency in the world was without precedent. That may well be one reason the market has been surprised by the extent of the move in the EUR over the past few quarters.
It seems that the release of the latest COFER data has shed some light on one reason why the move has been so quick: the reserve managers. Now, reserve managers tend to act as a market stabilizing force; they tend to want to keep their allocations to various currencies broadly stable, so if one currency appreciates sharply vs another, the reserve managers tend to sell the one that strengthened, while buying the one that weaked – at least over the short run. However, in 2H 2014, they seem to have stepped away from the EUR. From JPM:
The proportion invested in EUR assets declined significantly in Q4, to 22.2%, the lowest percentage since 2Q2002. Further, the decline experienced over the last year was the sharpest witnessed since the EUR’s inception. Prior to 2009 the allocation to EUR assets was on the rise. However, during the last four years this trend has reversed, with the allocation falling by roughly 1ppt per year…
Currency depreciation during the quarter caused passive declines for everything except the USD. However, reserve managers swam against the strong USD tide, concerned that FX movements were driving non-USD allocations below target. Net of currency effects, they were significant buyers of CHF and JPY, and moderate buyers of GBP, CAD and AUD. However, they allowed the weaker EUR to drive that allocation lower, pretty much unresisted. This reflects medium-term concerns regarding their prodigious exposure to the common currency.
Here is are a couple tables showing the data in more detail. The US, EU, Japan, and UK all conducted QE from 2008 to 2014, yet the share of FX reserves in USD only fell 0.9%, the share in Yen actually rose by 0.5%, but the share in the EUR declined by a full 4.0%, with about half of that move occurring in the second half of 2014.
Per FTA & Deutsche Bank,
The IMF data excludes two of the world’s largest holders of FX reserves, holding as many assets as the rest of the world’s central banks combined. It is precisely these holders that have the largest ongoing potential to sell Euros:
(1) The Middle East. The region currently holds 1 trillion dollars in official FX reserves and another 2.5 trillion via large sovereign wealth holdings. It just so happens that this region is also running very large fiscal deficits due to the collapse in oil revenues. The most natural source of financing for these countries is to run down reserves: there is little reason to increase government borrowing or aggressively cut back spending until the oil market price war reaches a conclusion. We estimate that Middle East oil producers are running a combined fiscal deficit of more than 200bn in 2015, and low-yielding European assets seem like the primary candidates of assets to be sold.*
(2) China. The country may be the world’s largest holder of FX reserves, but it is also running these down at the fastest pace in history. Assets are dropping at an annualized pace of around 200bn USD, driven by central bank intervention to accommodate large-scale capital outflows. In turn, these have been caused by a reversal in the structural CNY appreciation pressure that has been in place over the last two decades: increased corporate hedging activity, an unwind of speculative “hot money” inflows and hedging of outstanding portfolio exposures. All look likely to stay for this year and beyond.
In conclusion, it does not take an active re-allocation of central banks away from euro reserves to prompt capital outflows from Europe. The Middle East and China stand out as two regions that are likely to face ongoing pressures to run down reserves over the next few years, with low-yielding European reserves likely to be the main casualties of the post-EM and commodity boom trends.
In aggregate, the behavior of FX reserve managers may be one of the transmission mechanisms of negative rates in particular. That may be one reason the power of negative rates has been so surprising – something that central banks globally are likely to remember the next time they face output gaps.
Separately, Risk Parity has been a pretty popular strategy the past few years. There are many flavors, but the high sharpe ratio over the past few years has resulted in a number of new funds that follow the strategy. Unsurprisingly, future returns are unlikely to match that of the recent past. That because the main reason for the performance of the strategy has been the decline in the discount rate for all financial assets. With that discount rate broadly stable over the past couple years, the discount rate tailwind for Risk Parity has eased.
The chart below highlights the idea. I calculated a rolling 5yr annualized return for a 10% vol Risk Parity portfolio consisting of only S&P and US long bond futures. Against that, I charted the 5 year change in the 10yr TIPS real yield. The rationale is that the TIPS yield was a proxy for the discount rate. A decline in the discount rate should result in higher risk parity returns; a rise should conversely result in lower returns. I plotted the yield change with a lead of 3 years because it has historically taken time for the lower discount rate to become reflected in asset prices.
In aggregate, the data appears to support that rationale. Risk parity strategies did not particularly shine in the final years of the last decade, as the Fed’s hiking cycle raised discount rates. With the Fed nearing hiking again, it seems quite likely that we see a repeat of that. And if history is any guide, Risk Parity returns over the next 5 years are likely to fall quite sharply from those of recent memory.
Upcoming:
- Thu: US Jobless Claims, Yellen Speaks
- Fri: US Employment
- Mon: US Markit Services PMI, ISM Non-Mfg,
- Tue: RBA, EU Services PMI,
- Wed: Dudley Speaks, FOMC Minutes
Global Macro Trading 