Article

Central banks feel the pain

Higher interest rates have impacted the value of central bank’s holdings of bonds bought to prop up markets in the Covid era

| 5 min read

Most investment analysts and commentators hang on the words and deeds of the leading central banks. The prices of bonds depend on the decisions they make about interest rates. Bond prices usually fall when they hike and rise when they cut. Where a bond offers a fixed amount of interest each year to the owner the price someone else will pay for that bond will be lower when the interest rate on savings rises.

In recent years, the prices of shares have also been heavily influenced by how much extra money central banks are creating and spending on financial assets. We lived through a period of the US, Euro area and UK central banks expanding their balance sheets by buying up more and more bonds. Japan had been doing this for many years to recover from its large banking and property crash of the last century. Many of the funds and savers who sold bonds to the central banks then used the cash to buy shares or properties, boosting the capital values of these assets as the Central Banks boosted the price of the bonds. The Bank of Japan added to the purchases of shares by buying some share funds itself.

Keeping interest rates very low by buying up lots of bonds turned out to be inflationary when the leading western central banks did it for too long. They continued well into the recovery from the Covid-19 lockdowns. In Japan, inflation stayed lower, where the central bank kept its bond purchasing to similar levels to those prior to the lockdowns. Less of the money gets lent on to boost demand in an inflationary way in that society.

Inflation changed everything

Policy had to change at the Federal Reserve (Fed), European Central bank (ECB) and Bank of England to curb inflation. They went for a series of interest rate increases which drove down the price of bonds and last year hit shares as well. To reinforce the impact of their rate rises the central banks announced an end to bond buying and went on to announce they would not reinvest the money as bonds matured and they got the money back on some of their holdings. The Fed and the Bank of England decided to accelerate the process of shrinking their bond portfolios by selling some in the markets before they reached maturity.

The central banks paid for the bonds they bought by creating money. They say the bonds are financed by commercial bank deposits or reserves held at the central bank. It could work like this. A fund sold a bond to the central bank. It was credited with money in its commercial bank account for the sale. The bank receiving the cash was able to deposit more with the central bank.

In the glory days of this so-called quantitative easing, the central banks made good money out of it.

In this simple case, the central bank balance sheet was increased by the amount of the bond purchase, with the bond shown as an asset. The matching liability could be the deposit of the sale proceeds of the bond back at the central bank by the commercial bank of the bond seller who now held that cash for his client. In the glory days of this so-called quantitative easing, the central banks made good money out of it. With interest rates around zero they paid little or no interest to the commercial banks for their reserve deposits, whilst they got some interest on many of the bonds even at the very inflated prices they were paying. The central banks typically paid away the profits to their owners or kept some of it as a reserve.

Losses mounting

Once they stopped buying bonds and raised rates, they began to incur losses. The value of their bond holdings fell sharply to reflect the new higher interest rates. As bonds fell due for repayment the banks often realised a loss as in many cases they had paid more than the repayment value when they bought them. They incurred running losses, as they were paying the new bank rates they had established on the reserve deposits to the commercial banks. These now exceeded the income they were earning on the bonds. Where a central bank sells some of its bonds in the market it usually makes bigger losses as prices have fallen since their purchase. The issue arose over accounting for and paying for the losses.

The Fed said it would report the losses and put them on its balance sheet. It argues it is not a normal commercial company that has to keep assets on its balance sheet in excess of its obligations to carry on trading. A central bank can create money to pay its bills whatever its balance sheet says. The Bank of England negotiated a full indemnity from the Treasury, so it will receive pound for pound reimbursement of its losses leaving its balance sheet undamaged.

The issues surrounding the European Central Bank are more complex given its different ownership structure and relationship with the member states that sponsor it. You can read more in depth about that here.

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Central banks feel the pain

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