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| Central Banks Can Lose Money, Too! - Dec. 1, 2004 |
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Summary
Yes, Virginia, central banks can and do lose money. And most foreign central banks that hold lots of US Treasury and agency securities have lost a bundle lately!
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On more than one occasion lately, I've gotten the impression there are people, perhaps many people, who believe that for some reason, central banks are immune from losing money on their security holdings. Which, of course, simply is not the case. And because of the dollar's recent slide in its exchange-rate value, there are many central banks as well as other overseas investors who are licking some rather deep wounds.
Sometime in the future, I will provide a more elaborate example. But for now, here's something that will make do in illustrating the blood that is flowing abroad, as a result of the dollar's decline.
Let's keep the assumptions simple but conservative. To wit:
(1) Let's take a foreign central bank holding US government securities with, say, a book yield of 3%. With perhaps the exception of the Bank of Japan, this is a generous yield assumption, since it would be consistent with an average maturity that is longer than most central banks would have. Nevertheless, assuming a higher book yield is actually being conservative, because it results in understating the magnitude of recent total-return losses.
(2) For simplicity, let's assume that whatever central bank we're talking about has a currency loss versus the dollar that is equal to the decline in the Dollar Index.
(3) For measuring purposes, I'm going to look at the period from 9/10/04 through 11/30/04. Why? -- because it was on 9/10 I published a missive opining that the dollar was about to take a tumble.
(4) The Dollar Index on 9/10 stood at 88.92, versus its close yesterday of 81.82. Thus, the decline over this 81-day period was 7.98%.
(5) Finally -- another conservative assumption -- we will assume no decline in the principal value of the securities over the measuring period. In fact, there would likely have been some loss, even in something as short in maturity as a two-year T-Note. Between 9/10 and yesterday, the two-year note yield rose 53 basis points, from 2.47% to 3.00%.
Now, here's what happened:
Currency Return = -7.98%
Income Accrual* = 0.68%
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Total Return = -7.30%
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*Accrual calculated on standard 360-
day basis for US government securities:
81/360 x 3.00% (0.03) = 68 bp.
Ugly, ugly, ugly, particularly so considering the huge amount of US Treasury and agency debt that is owned by foreign "official" and "private" investors, and considering that the negative 7.30% return is not annualized. Annualized, the red ink expands to something approaching 33%!
There are some morals to this example, but none more important than the following. Each day, you only earn an accrual of 1/360th of the coupon, while the change in exchange rates can add or subtract from the value of your holdings much, much, much faster!
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