Brad Setser

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Scared (sovereign) capital

by Brad Setser
October 10, 2008

Central banks with lots of reserves have not been running away from the dollar. But they do seem to be running away from any dollar asset with a hint of risk. Right now, it is hard not to focus on the relentless slide of the stock market (the FT is calling this week a global crash), the enormous daily moves in the foreign exchange market or oil’s sharp slide. But New York Fed’s latest custodial data is stunning in its own way.

Since September 10, central banks have added close to $100 billion to their custodial holdings of Treasuries. Custodial holdings of Treasuries reached $1537.6b on Wednesday — up from $1513.1b last Wednesday, and up from $1438.1b on September 10.

Some of the increase in Treasury holdings is explained by a slight fall in Agency holdings — which fell from $956.6b on September 10 to $944.8b on October 8. But the roughly $8b fall in Agency holdings cannot explain the huge increase in Treasury holdings.

Solid data on global reserve growth in September doesn’t yet exist – China and Saudi Arabia matter, and they don’t release data quickly. But the reserves of nearly every country that reports data quickly fell in September. I have no doubt that the Fed’s custodial holdings are increasing far more rapidly than global reserves.

That either means that:

a) Central banks are shifting from euros to the dollar, adding to their dollar holdings;

b) Central banks reserve managers have also lost confidence in the international banking system — and in money market funds — and are moving into the safest dollar asset around.

I would bet that this is more a flight away from risky dollar assets toward Treasuries than a flight into the dollar.

Central bank reserve managers are scared. Understandably so. Central bank reserve managers’ primary goal is to avoid losing money — and to have all the liquid assets their country needs. Right now that means holding Treasuries and not much else.

But their actions also aren’t making the Fed’s job any easier.

There isn’t a shortage of demand for US Treasuries right now. There is by contrast a shortage of institutions willing to lend in dollars to a host of banks — or cut into the Treasury-Agency spread by selling Treasuries and buying Agencies. A year ago central banks couldn’t get enough Agencies. Now they won’t touch them, even though they are far better substitutes for Treasuries now than they were then.

UPDATE: Kuwait’s sovereign fund is gearing up to support the local market, which likely means that it is building up its liquid holdings abroad. I am also fairly sure that Norway’s fund isn’t the only fund in the unfortunate position of having lost a lot of money over the past year. Saudi Arabia’s fairly conservative portfolio almost certainly has outperformed Kuwait’s portfolio, or Abu Dhabi’s portfolio. A lot of oil funds invested a lot of money at what now looks to be the peak of a host of different markets. Hat tip: SWF Radar.


  • Posted by LB

    awesome find moldbug.

    is there any banks that exist today to your knowledge that apply these principles?

  • Posted by Bernardo A

    Dear Brad,

    we are experiencing the worst financial crisis after 1929, and this seems the obvious consequence of years of living above their possibilities by the US citizens, i.e. of a massive US current account deficit and negative savings. Crises, as hangovers, may be helpful to restore integrity. But what if integity will not be restored after this crisis? In other words, what if, say in two years time, the US financial system will be bailed out but still characterized by a massive external deficit? I would not be so confident, as you are, the the CA deficit will shrink by more than the IMF predicts.

  • Posted by mel

    “I would bet that this is more a flight away from risky dollar assets toward Treasuries than a flight into the dollar.”

    That is precisely correct sir, and it is the reason why they will lose more. This time they are selling risky assets when they should buy them, and buying treasuries when they should sell them.

    Correct course of action here is to do the opposite of Joe Public and Sovereign funds:
    Buy stocks, and sell dollar, and sell treasuries.

    To understand why, read posts from Friday to today, on these blogs:

    Sovereign funds and Joe Public share this in common: they are SCARED of risky assets at the BOTTOM, and CONFIDENT in risky assets at the TOP. The opposite of what they should do.

  • Posted by moldbug

    LB: no.

  • Posted by Michael

    We don’t need the government to invalidate ALL the Lehman (and other) CDS obligations (though that would be fine with me – I proposed a total CDS moratorium here at this blog last week before the settlement).

    Of the $400 billion in Lehman CDS liabilities, “only” $128 billion was actual insurance for real owners of Lehman bonds. The remaining $272 billion represented pure speculative plays (or some ninth-level-of-hell complex counter-counter-party pseudo-hedging, which is operationally the same thing).

    Get out your calculators: What’s the leverage when $170 million in premiums was paid by these speculators on the gamble they would receive $272 billion if Lehman defaulted? Do they have a right to get fabulously rich at the expense of the world economy? No wonder they banned short-selling for a while; with this kind of potential returns at stake, you mortgage the children if necessary to short Lehman).

    The compromise resolution is to validate the $128 billion in CDS obligations that was real bond insurance (there’ll still be some bailing out necessary of the insurers who can’t pay up), but CANCEL the $272 billion in CDS obligations to the non-bondholders (they didn’t have that much skin in the game in the first place).

    Make a clear, firm, absolute policy that henceforth all existing non-bond-insuring CDS are WORTHLESS JUNK that shall NOT be paid. Problema resuelto!

  • Posted by LB

    “Problema resuelto!”

    si si si,

    EXCEPT for one rather formidable obstacle.

    JPM has $8T in notional CDS exposure.

    that’s 8,000,000,000 dollas.

    of course, they’re playing market marker. now let’s assume they played good market marker and balanced out their risk. they’re still making the spread on every transaction, yes?

    correct me if i’m wrong, but under your proposal, they don’t get to collect the spread if the contracts are deemed null & void, correct?

    how much do you think the spread is on $8T of CDS?

    how ever much is the size of your obstacle.

    (and behind that hurdle are smaller hurdles, BOA, CITI, etc.)

  • Posted by vlade

    LB: “is there any banks that exist today to your knowledge that apply these principles?”

    Sort of. Zopa ( is (or was, I haven’t looked recently) a loan market matching bank, where you lend to a specific borrower, for a specific term. So, no MT.

  • Posted by LB

    vlade, this zopa link is wonderful.

    thanks for sharing.

    perhaps a glimpse into future possibilities???

    here’s another…

  • Posted by Michael


    Well, we have to decide who “wins” and who “loses,” anyway, now that we’ve decided not to let the free market operate freely. My compromise supports the integrity of bond insurance and does not support other functions of CDS. Agreed, it’s arbitrary. The alternatives appear to be:

    1. A meltdown of the $62 trillion CDS obligations as the deleveraging and defaults proceed. JPM’s $8T is a fraction of what’s to come. Oh yeah, we’re still living in the fantasy world that the Central Banks can prevent further deleveraging…HAHAHAHA.

    2. Paulson guarantees all CDS obligations to be “backed by the full faith and credit of the U.S. Government” (like everything else). Why not? It seems like the obvious next step.

    My problem with #2 is that when all currency becomes dollars and all debt becomes Treasuries, then the benefits for America of having a special currency and a more credible debt instrument disappear. All this, just to get through a classic credit contraction!!