Negative euro zone interest rates may be forcing central banks to rethink how much of their foreign cash hoards they bank in euros, with a recent drop in euro reserves potentially the start of large-scale rebalancing that could depress the euro further.
Central banks cut their euro holdings in the second quarter, in the largest drop in almost two years, according to figures from the International Monetary Fund last week, and analysts estimate their sales at around $40 billion worth when adjusted for exchange rate and valuation effects.
That is a sizeable shift and entirely due to emerging market central banks. But it's unlikely to be a one-off if the driving force is negative interest rates, analysts say.
Since the European Central Bank cut the interest rate on deposits at the bank to below zero on June 5, the yield on no less than seven euro zone countries' short-term government bonds has followed suit and turned negative.
This means that central banks are literally paying for the privilege of holding some of their euro-denominated assets. At the last count, central banks held an estimated 24 percent of their record $12 trillion reserves in euros, or almost $3 trillion worth. At the peak in 2009, the euro's share of reserves was an estimated 28 percent, although 10 years ago it was broadly where it is now at about 23 percent.
That doesn't imply net selling of euros over the past five years. The nominal amount of euros bought for reserves has risen, but the effects of exchange rates, valuation, relative returns and diversification into other currencies has to be taken into account.
The drop in the second quarter, however, is unusual given how rare any sustained change in the overall reserve ratios has been and analysts say this indicates the negative interest rate factor may become highly significant.
Of the current euro total, almost 1 trillion is invested in assets such as deposits, T-bills and short-dated bonds that are exposed to negative yields, according to Nomura.
"Even if just 10-20 percent of these assets are affected, from a currency perspective we are talking about flows of around 100-200 billion euros," said Jens Nordvig, global head of currency strategy at Nomura in New York.
Yields on US bills and short-term bonds plunged towards zero in the wake of the financial crisis, but almost never below, thanks to the pivotal and pre-eminent status of the US currency and rates markets in the global financial system.
Central banks typically hold hard cash reserves as a precautionary buffer against sudden currency or balance of payments crises, as well as natural disasters and emergencies. As such, they prioritise holdings in highly liquid and relatively safe assets that can be accessed swiftly at short notice. They are active and influential players in the currency market, but tend to conduct their business gradually and as discreetly as possible so as to minimise market volatility and rarely change models dictating the mix of reserves they hold.
Total world-wide reserve holdings now exceed $12 trillion - two thirds held by emerging markets and half of that by China alone - which is up from $11 trillion a year ago and just $2 trillion in 2001. Like private sector investors, central banks have seen the return on their deposit and fixed-income holdings dwindle as major central banks have slashed interest rates to virtually zero since 2008 to cushion the blow from the financial crisis.
In the euro zone it has gone a step further and authorities are battling against low growth and the threat of outright deflation, and nominal losses are now being baked in.
The ECB has launched a series of policies to boost the economy and inflation, but as they have yet to produce results a growing number of analysts expect the ECB will eventually have to undertake asset purchases with new money - so-called quantitative easing.
"More aggressive easing by the ECB in coming months, potentially including even lower deposit rates, could encourage further diversification and weigh on the euro," said Valentin Marinov, senior currency strategist at Citi in London.
Central banks are bound by their mandates to invest in high-quality assets. But the more the yields on these assets turn negative, the pool of these eligible investments shrinks.
Countries bearing negative-yielding assets include Germany, France, the Netherlands and Austria, all "core" euro zone countries with high credit ratings that central banks' reserve managers gravitate towards. But central banks want liquidity, as well as credit quality. And outside Germany and possibly France, no euro zone country really offers a satisfactory combination of the two.
Some reserve managers might well be inclined to maintain their euro holdings but invest instead in bonds of longer maturities or higher-yielding assets like supranational or agency bonds. This would have no exchange rate effect but could have the net result of depressing long-term interest rates. Others will be inclined to simply reduce their euro holdings.
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