Out of the Box #21: Central banks are insolvent. How do we deal with it?
In our “out of the box” series, we aim at being ahead of the current consensus narrative and think of the next theme that could drive price action before anyone else has given it any noteworthy attention. This week we look at the insolvent G10 central banks and how to deal with them.
Yes, you heard us right. The Fed is insolvent. The ECB is insolvent. The Riksbank is insolvent.. and the list goes on.
It is probably not a newsworthy conclusion to central bank aficionados, but the big question is whether it matters and potentially WHEN it matters. We have used the Federal Reserve as an example throughout this analysis, but the same analysis goes for (almost) all other G10 central banks with large QE holdings from the period between 2015-2021.
Conclusions up front:
– All larger G10 central banks need recapitalization either via the Treasury or via future earnings not being paid to Treasuries as remittances
– An insolvent central bank is an issue if 1) The bond holdings need to be sold ahead of maturity or 2) If larger aid packages/liquidity facilities are needed for the banking system with markets in the know about the insolvency
– Markets may test local government bond markets in countries with highly insolvent central banks as they know the claim is de facto on the government/taxpayer ultimately
Question 1: Why are central banks insolvent?
A central bank operation is pretty simple if you think about it. They earn interest on “assets” and pay interest on “liabilities”.
The majority of the central bank balance sheet asset side is made up of holdings of bonds after years of QE, while the liability side is mostly made up by bank reserves held at deposits in the central bank.
After years of buying bonds with low coupon rates (due to the low-interest rate environment), central banks now simply pay more in interest on bank reserves held at deposits than they earn from running coupon payments on bonds held in the portfolio. That leaves a running cash-flow deficit to deal with.
Chart 1: Interests paid versus interest received in the Fed equation