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June 18, 2007

Super Heroes of Central Bank Policy
by Adrian Ash

"Is it a bird, is it a plane...or is it a central banker wearing his underpants over his trousers...?"

JUST HOW POWERFUL are the world's central bankers? As comic-book super heroes go, these mild-mannered scholars would no doubt confess that they look a bit weedy.

The massed talents of the Federal Reserve or Bank of England, for instance, hardly ever leap over tall buildings in a single bound. Ben Bernanke and Mervyn King don't own a flowing cape between them, not judging by the multi-year wait for long-dated bond yields to catch up with their gently rising overnight base rates.

Buried deep in data and research reports, the Bank of Japan rarely does whatever a spider can, either. Holding the cost of short-term money at 0.5% or below for the last dozen years, for example, the Bank has still failed to ignite Japanese consumer spending.

And head of the European Central Bank, Jean-Claude Trichet may claim to glare at Eurozone money-growth data month after month. But now it's rising at the fastest clip in more than two decades, Europe's M3 money-supply mocks his "hard stare" as more Paddington Bear than X-ray vision.

Of course, "with great Power there must also come great responsibility!" as Stan Lee captioned SpiderMan. And that might go some way to explaining why the world's central bankers have been so reckless with the interest rates that they're supposed to control.

Beyond setting the short-term price of debt today, central bankers now have few super-human muscles worth flexing. Yes, as a sub-set of policy maker, the modern-day central bank wonk has gained ever more "independence" from elected governments worldwide. But he no longer sets capital adequacy standards (see Basel I and II instead, as agreed by the Bank for International Settlement); some have even lost control of banking reserve-ratio requirements. The Bank of England, for instance, was forced to cede this power to the UK government-run Financial Services Authority nearly 10 years ago.

Capital controls tend to sit with the finance ministry, meantime...sanctions are decided by government for announcement through the central bank only...and with outstanding derivatives contracts now outweighing the entire global economy more than eight times over, you'd have to do more than wear your Jockeys over your tights to keep credit in check.

Then there's the exchange rate - only here, central bankers find their powers sapped not by government meddling, but by that kryptonite known as "the market".

"The Bank of Japan has not intervened in the foreign exchange market since 2004," notes Tony Tassell in the Financial Times. "It has been even longer for the US Treasury and the European Central Bank, with neither dipping a toe in since 2000. The hoo-ha over the Reserve Bank of New Zealand's attempts last week to stem the NZ dollar's rise highlights how rare interventions now are in the developed world."

"Central bank reserves are just too small to take on currency markets for long," Tassell explains. "But even as a signaling device, much depends on credibility and timing. There is no point putting money where an authority's mouth is if it has lost the market's respect. Nor should central banks try to stop a trend in full flow."

The hottest trend in full flow right now is the sell-off in government bonds. It's matched by a concomitant rise in government bond yields, of course. Nearly four years after the Bank of England, for example, picked its overnight lending rate off of a half-century floor of 3.50%, ten-year gilt prices have sunk so fast in the last month that - finally - the bonds very nearly yield the same as the current BoE base rate at 5.50%.

Will Mervyn King and his team push rates higher again in July? Even if the rise in 10-year gilt yields was desired by the Trimmer, his boss at the Treasury would rather the "bond market conundrum" remained an enigma. Gordon Brown is now planning to raise a further £46.6 billion (more than $90 billion) from the City of London before April '08. But just as he's picking out new carpets and drapes to replace Tony Blair's feng-shui'd furnishings at No.10 Downing Street, Brown finds that borrowing to cover his programs and projects is more expensive than any time since summer 2000.

Can Mervyn King help? The Sterling futures market now expects 6.0% base rates by the end of Sept. - and slashing rates now would most likely fail to cut longer-term debt costs, just as raising the price of money took nearly four years to reach 10-year gilt yields.

What about gold? Can't central bankers at least control what happens to the "barbarous relic" that still lurks in their vaults three decades after the International Monetary Fund cut it out of the global financial system? As the largest owners of gold, surely the world's central bankers can repel its verdict on their management of official government money?

"Despite the demonetisation of gold, the yellow metal continues to have a special significance for central banks," noted Philipp Hildebrand, a member of the governing board of the Swiss National Bank - and now it's vice-chairman - at a conference in June 2006.

"Unlike currencies, the value of gold does not depend on a national sovereign. Moreover, payment transactions with gold are fully under a central bank's control. These are two important reasons why gold, more than any other type of investment, serves to ensure the capacity to act in extreme crisis situations."

No one's talking about a crisis today, of course - and perhaps our crisis-free future explains why the Swiss National Bank is going to sell around one-fifth of its remaining gold reserves between now and summer 2009.

The official reasoning looks as mundane as Peter Parker in his thick-rimmed spectacles. "As a result of the sharp rise in the price of gold," said the SNB last week, "the proportion of [our] currency reserves held as gold has increased by about a quarter since mid-2005, from 33% to the current level of 42%. The purpose of the SNB's gold sales is to rebalance the composition of currency reserves with respect to its monetary policy requirements."

In other words, the Swiss National Bank wants to re-weight its portfolio - as any wise investor would do if they had an institutional mandate to meet - by reducing its gold holding and buying more of the under-performing assets that litter its vaults. The SNB, in short, is joining the worldwide scramble for higher-yielding assets. So are its fellow supermen at central banks everywhere.

"Earlier this month," notes Tony Jackson - also in the FT - "UBS polled 80 central bank reserve managers on their investment intentions over the next decade. Asked what the one biggest change would be, 38% said they would buy more so-called 'spread product' - that is, any form of credit except US Treasuries. A further 18% went for more equities and 12% for alternative assets such as hedge funds and private equity.

"So more than two-thirds said, by implication, that they would reduce their weighting in Treasuries. This seems perfectly healthy. To date, the vast majority of reserve managers have not been allowed to buy riskier assets. As they gain permission and the necessary expertise, the price of Treasuries will cease to be distorted by massive forced buying."

Does this quiet grant of "permission" explain the sharp sell-off in US bonds starting in May? The Japanese authorities had put their purchase of US Treasuries on hold so far in 2007 before growing their pile of Washington's promises by 0.5% in April. China cut its holdings by 1.3% that same month, however, while South Korea kicked out one US bill, note or bond in every fifteen that it owned. The oil-rich Opec states lightened up on US Treasuries by $0.5 billion in April.

"By reducing its gold reserves and increasing its foreign exchange reserves, the overall risk on SNB assets will decline," claims the Swiss National Bank. This view, classing gold as a risk asset - alongside bonds, equities and foreign currencies - might seem to jar with the stated aims of central banking at the start of the 21st century. Price stability in the domestic economy, matched by a smooth-running financial and banking system, are surely heroic ambitions enough!

But "what we aim to do is to sell gold, an unprofitable asset, to reinvest in bonds, which are more profitable," according to Spanish finance minister Pedro Solbes. He's presided over record gold-sales from the Banca d'Espana in 2007 to date - and "the objective of our reserves is to maximize their profitability," he claims. Senor Solbes neglected to mention the yawning trade deficit that Eurozone interest-rates set below the rate of Spanish inflation have now helped to push above 9% of Spain's gross annual economy.

What of his poor, cowed team at the Bank of Spain? If they ever hoped to gain real super-hero status, they might do much worse than hang onto what little gold Madrid still has left in its vault. Turning a profit on rainy-day money today would bring them far less glory than having gold in the bank to cover an "extreme crisis situation" - whatever it might prove to be next time it shows up.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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