Risk Managers Should Brush Up on Central Bank Kremlinology
Banks like Cullen/Frost and BOK Financial say they have found one, in the form of higher energy-sector loan balances last quarter and the chance to finance consolidation among oil firms. But such spurts may only mask longer-term problems.
No one can agree on what the Fed will do with interest rates. In the meantime, the banking industry's more-conservative players are devoting more resources toward hoarding low-cost deposits and purging shorter-term borrowings.
It's only the beginning of 2015, and portfolio managers around the globe are already confronting country risk in ways they barely had to consider last year. When portfolio managers typically think about country risk, they think about a sovereign's ability and willingness to pay its debt, along with the country's political stability, threat of expropriation and exchange controls. But country risk also encompasses central bank policies and actions.
I realized that 2015 will be the year of central bank Kremlinology as I talked with fellow panelists and conference participants at a recent Trade Tech Foreign Exchange conference in Miami. Corporate risk managers, especially those at financial institutions, will need to decipher how unforeseen central bank monetary policies and actions could impact their earnings and capital. This is a good time for risk managers to reevaluate their capital models to see if they really can withstand unexpected losses.
Being a central bank Kremlinologist is no easy task. After all, "central bank policies are varying significantly across the globe," said Mike Harris at the investment management firm Campbell & Co.
Central bank actions can also be unpredictable. The first rude shock of this year arrived on Jan. 15, when the Swiss National Bank unexpectedly removed its currency peg to the euro. Due to low interest rates in continental Europe and investors' pursuit of higher-yielding assets, the Swiss franc had been appreciating against the euro, adversely impacting Swiss exporters.
The Swiss central bank's action caused banks as well as asset managers, insurance companies, pension funds, hedge funds millions of dollars in losses in a very short period of time. We will have to wait until the next earnings season to know the full extent of the damage.
Unsurprisingly, the SNB's decision was unpopular with many fund managers. Josh Levy, managing director at Tactical Asset Management, passionately argues that it is the "responsibility of a central bank to maintain the stability of markets." According to Levy, there is no reason that the SNB "could not have announced its revaluation peg."
While I can certainly understand his frustration, a central bank's job is to focus on inflation, gross domestic product and unemployment. In the case of some countries, such as the U.S., a central bank may also have bank supervisory responsibilities. But a central bank is not responsible for managing market participants' portfolios.
Hence, risk managers need to understand that central bank actions around the world will be influenced primarily by three factors this year: a weak continental European economy, a strengthening U.S. economy and current global oil prices.
The Danish and Swedish central banks have recently lowered interest rates in order to battle very low inflation. In the U.S., most market participants expect the Federal Reserve to raise rates in the next 12 months. Together with an expanding U.S. economy, an interest rate hike is likely to put more upward pressure on the dollar.
During the global financial crisis and the years since, central banks globally had been diversifying their foreign exchange reserves away from U.S. dollars to euros. However, "now they are likely to go back to the dollar pushing it up," explained Marc Chandler, a political economist at Brown Brothers Harriman.
Peter Hooper, chief economist at Deutsche Bank, agreed at the conference that near-term expectations are for a strong dollar.
Declining oil prices are also influencing central bank actions. On Jan. 28, the Monetary Authority of Singapore intervened to weaken the Singapore dollar, which caused it to decline to the lowest level since 2010. This action caught the market completely by surprise.
Singapore is an oil-importing nation. As oil prices have declined, the country's economy and currency have become more attractive to investors. Yet uncontrolled appreciation of the Singapore dollar would hurt the country's exporting competitiveness. That is why the central bank intervened.
It would behoove portfolio and risk managers to analyze the central banks both of major oil producing nations and of the major importing ones. The central banks of oil-producing nations may lower rates to spur economic activity, as Russia recently chose to do.
Countries that import oil, such as India, have the opposite problem. They will have to fight significant appreciation in their domestic currency, which would make their exports less attractive. This could lead a central bank to lower its interest rates or to intervene in the foreign exchange markets to sell its currency, typically against the dollar.
Coping with oil price volatility will pose a true challenge for financial institution risk managers, since the prices are influenced by multiple and often simultaneous, global forces of supply and demand. "The actions of the Swiss National Bank are much more predictable than oil prices," argues Kevin McPartland of Greenwich Associates. "Every central bank is always so focused on developments in its own country." Risk managers can generally expect a central bank to defend its nation's interest. Changes in oil prices, on the other hand, are much harder to foresee.
Financial institutions with significant foreign exchange, securities and derivatives portfolios will need to remain attuned to how good their personnel is at trading in volatile times. Financial institutions have spent millions transitioning to electronic trading, but in uncertain times humans may be better at assessing how country risk, such as a central bank's action, can adversely impact a portfolio.
Algorithms "work well in predictable times," McPartland said. "But what about in unpredictable ones?"
One thing is clear: no amount of algorithms and technology can help risk managers in the art of central banking Kremlinology.