SEMI-MONTHLY FISCAL/MONETARY UPDATE – CENTRAL BANKS ARE BUYING BIG – SELL TO WHOM?

It is becoming increasingly clear that currency creation by Central Banks of major industrialized countries is reaching dangerous proportions.

We all know by now that Central Banks have artificially suppressed interest rates, in the (so far) vain hope of encouraging capital investment and stimulating economic growth. We shouldn’t forget that the flip side of that process involves “mis-allocation” of financial resources, as (1) companies “reach” for return in deals that make little economic sense with investment capital with so little interest rate cost and (2) individuals that similarly “misallocate” their savings, reaching for yield they need without understanding the risk involved. This process will inevitably run its course and there will be a lot of damage, perhaps far exceeding the 2007-2008 financial crisis, but the timing is of course uncertain.

Another increasingly dangerous corollary of Central Bank currency creation is the purpose to which those funds are put to work. It is well known by now that the US Fed, the European Central Bank and others have been active to the tune of hundreds of billions of dollars in the fixed income markets, which have been instrumental in keeping rates low. This has artificially inflated bond prices, in turn driving investors into the equity markets for alternative returns. What is not so well known is that Central Banks have been buying hundreds of billions of dollars of equities. Since major Central Banks cumulatively hold over $11 trillion of foreign currency reserves, it is natural that they should want to diversify those reserves away from the currencies which are being continuously diluted. Along with steady buying of Gold (which we suggest is the “real money”), the Central Banks have increasingly added equities to the portfolio mix.

The Bank of Japan has been buying Japanese ETFs at the rate of $53 billion per year, and now holds over 71% of those ETFs. The bank is now one of the top 5 owner of 81 companies within Japan’s Nikkei 225 index. As reported by Grant’s Interest Rate Observer, the Japanese Financial Services Agency (Japan’s SEC) is now “paying close attention” to this phenomenon.

The European Central Bank has been buying 60 billion euros worth of bonds monthly, and Mario Draghi is going to update their plans tomorrow. In the meantime, Deutsche Bank CEO, John Cryan, has said: “There has been absolutely no price discovery now in corporate bonds….which is a very dangerous situation”.

The Swiss National Bank has been steadily buying equity securities, including US based companies. Equity securitie, as of Q3’16, comprised 20% ($128 billion) of their of their $643 billion in foreign exchange reserves, up from 7% in 2009, including investments of $1.7 billion in Apple, 1.08 billion in Exxon, and $1.2 billion in Microsoft.

Here in the US, our Fed has talked about beginning to unwind our $4.2 trillion balance sheet by no longer reinvesting the funds from securities that are maturing. The result of this form of money “tightening” can only be a guess, especially relative to already soft economic trends.

These are serious amounts of capital being to work in an increasingly dangerous way. To some extent, Central Banks are biased toward continued equity (and bond) buying, because their absence from the marketplace would cause a price decline and trillions of dollars of “paper losses” on their respective balance sheets.

I’ve been in the financial world for many decades, and learned (the hard way) that when you get the feeling you are “responsible” for supporting a particular market, the best possible strategy is “get out of the way”, take the current loss before it inevitably becomes much larger. The key question, at this point for Central Banks, now becomes “Sell to Whom?”.