The Return of Safe Assets
A major market concern in the aftermath of the most acute phase of the global financial crisis was an encroaching shortage of safe assets, defined as debt securities with low market and credit risk trading in highly liquid markets. More recently, the supply-demand balance has shifted in favour of a return of safe assets. In 2015 the global supply of safe assets (in US dollar terms at end-year exchange rates) increased by the largest amount since 2011, and official sector demand from central banks’ quantitative easing (QE) programmes and foreign exchange reserve management activities was the lowest in more than a decade.
Supply: Rating Changes and Fiscal Consolidation
Highly rated sovereigns are the most important suppliers of safe assets, but with clear limits. Those with large fiscal deficits and growing debt burdens – initially increasing the supply of safe assets – run the risk of rating downgrades, which would dramatically reduce safe asset supply. If we consider safe assets to be central government debt securities rated no lower than the ‘AA’ category, sovereign downgrades during the crisis that meaningfully reduced the stock of such assets included Italy (2011) and Spain (2012). These downgrades reduced euro-denominated safe assets from EUR5.2trn in 2010 to EUR3.5trn in 2012.
Even if Italy and Spain had retained ratings in the ‘AA’ category, the annual growth of euro-denominated safe assets would have peaked in 2009 (at EUR524bn), when eurozone fiscal deficits were largest. The combination of fiscal consolidation in subsequent years and sovereign rating downgrades resulted in a marked decline in additional safe asset supply, to only EUR54bn in 2015.
The US Treasury market is by far the most important in the global provision of safe assets, accounting for about 45% of central government securities rated in the ‘AAA’ and ‘AA’ categories issued by sovereigns whose currencies are typically held as official reserves. With no loss of high-grade status of the US during the crisis, changes in the supply of US dollar-denominated safe assets varied only with the net issuance of Treasuries, which peaked in 2010 at USD1.6trn, and fell to USD687m in 2015.
Demand: Quantitative Easing and FX Reserve Accumulation
Analysing only changes in the supply of safe assets does not fully reveal why market participants were concerned about a pending shortage as the nancial crisis evolved. The real issue was dwindling supply in the context of growing o cial sector demand. In 2011-2013, when the safe asset shortage was receiving most attention, supply increased by an average of USD257bn a year but official sector demand grew by an average of USD1.5trn.
Quantitative easing that affected government bond markets in the US and UK began in 2009. The Bank of England (BoE) continued to purchase Gilts until 2012, and the Federal Reserve bought US Treasuries until 2014. When the programmes ended, the Federal Reserve and BoE held 20% and 25% of their respective governments’ marketable long-term bonds.
In addition, while central banks in advanced economies were absorbing safe assets, so too were those in emerging markets, as the increase in official foreign exchange reserves that began in the mid-2000s continued without interruption during and after the global financial crisis. In fact, global reserve accumulation during 2011-2013 was about USD65bn higher than government bond purchases associated with QE.
The Balance Shifts
Several aspects of the supply-demand balance for safe assets have changed since 2011-2013, and this is likely to continue in 2016. The most dramatic change is the decline in official reserves (in US dollar terms) in 2014 and 2015. This was due in part to valuation effects – reserves held in currencies that depreciated against the dollar have fallen when measured in dollars – but there is strong evidence of capital outflows and currency pressures more generally in emerging markets, which suggests downward pressure on reserves will persist even if the dollar stabilises.
The global change for QE is more moderate and the future less certain, as Federal Reserve and BoE activities have given way to a new initiative launched by the European Central Bank and an aggressive expansion of the Bank of Japan’s (BOJ) programme, which began in 2001. However, the effects of QE in Japan (already rated below the ‘AA’ category) on the demand for safe assets could be considered a largely domestic affair, at least in that yen- denominated assets account for less than 5% of allocated global reserves. Even so, the global demand for safe securities from QE expanded last year, more than offsetting the decline in demand from the reduction in official reserves (all calculated at market exchange rates), and the same could happen again in 2016. But it does not appear that the official sector demand for safe assets will come close to the levels of 2011-2013.
On the supply side, rating Outlooks do not portend the downgrade from – or upgraded to – the ‘AA’ category of any large sovereigns with reserve currencies, implying the supply of safe assets will depend on the pace of fiscal consolidation. The latest Congressional Budget Office projections suggest a small increase in the US federal government deficit this year and a resulting rise in debt of USD635bn. In Fitch’s view, there will be a fiscal easing in the eurozone in 2016, but debt increases will be small in nominal terms and mostly falling relative to GDP.
Taken together, the new supply-demand dynamics for safe assets point toward a steady increase in global supply and a reduction in official sector demand, at least for dollar- and sterling-denominated assets. Active reversals of QE in the US and UK would accelerate the change, but are not expected in the near term. Markets for safe assets in Japan and the Eurozone remain dominated by QE.
James McCormack, Fitch Ratings Global Head of Sovereign Ratings