Interview: Golan Benita

The editor spoke with the director of the market operations department at the Bank of Israel on March 23, 2023.

Higher interest rates aiming to tame above-target inflation have contributed to lower asset prices across financial markets. What is your outlook for 2023? Do you think a soft landing is attainable?

A soft-landing scenario is still possible. But at the same time, we must consider the less probable scenarios. For instance, inflation in the US might be stickier than … was expected. Secondly, the recent developments in the banking sector are also a reminder that some of the effects of higher interest rates might be unexpected. At the same time, the tightening of financial conditions should help to bring back inflation towards central banks’ targets. 

The latest Fed dot plot was in line with what we expected.¹ I know that it’s far away from how markets are forecasting future interest rates. But this was our view from the beginning of the year. We think that the market is pricing inflation converging to the target faster than how actually it’s going to happen.

Uncertainty has increased substantially. If you [had] asked me a month ago, I would have said that the soft-landing scenario was likely. It’s true the concept is not very well-defined. Everyone has their own scenarios. But in general, what I think it means is that inflation converges a little bit above the target in late 2023. 

Given the activity data that we see right now, there might be some slowdown in the US economy, but not a deep recession. Having said that, we must bear in mind that we could encounter unexpected scenarios that might change this view. Barring these unexpected factors, our base scenario reflects a somewhat favourable forecast for the equity market. If you look back in history, as soon as you get to the terminal rate the equity market tends to do well. 

As the US Federal Reserve chair, Jerome Powell, signalled on March 7, rates are likely to be “higher than previously anticipated”. After his statement two-year Treasury yields reached 5% for the first time since 2007. And the yield curve inversion steepened to 104 basis points between the two- and the 10-year benchmark. In this environment, how can duration management contribute to limit portfolio losses?

Our approach is based on our strategic asset allocation. Our view is that the yield curve will continue to rise at the short end, and probably will flatten at the long end. But there is a lot of uncertainty. The monetary policy committee [MPC] that oversees the management of the reserves determined we should continue to maintain a conservative duration. Our duration is presently set at 24 months. It’s conservative relative to some other central banks. This is because there are considerable risks also at the end of the curve, at the long term of the curve, around 10 years.

For instance, some components of inflation are stickier than what we expected. There is the risk that the Fed will have to increase interest rates higher than the market prices. Eventually, that would affect long-term yields, putting us at risk. Given all that, the very high volatility of the bond market, it is prudent to be conservative with duration. Even though you might record some losses in environments like we saw in mid-March. Our view is to be around two years, which is less than the neutral duration for our portfolio (three to four years). 

Last year, the MPC decided to maintain duration unchanged even though duration and diversification made a negative contribution of 57bp basis points to the overall results. What was the rationale behind this decision?

The MPC took the decision in late 2021, when inflation was just starting to rise. Back then, the Fed and other central banks stated that inflation was temporary and was expected to go down very soon. Of course, there was a risk that the curve could rise. But I don’t think that anybody thought then that inflation would reach the levels it did in 2022. It was truly unexpected, and clearly impacted by the tragic war in Ukraine. Still, we always felt comfortable in our conservative duration.

On the other hand, our portfolio can reach a maximum of 27% in equity investments, given the chosen investment horizon of around three to five years. So, it would be rational to have a longer duration, between three to four years. So, we don’t only consider the very short-term performance. 

In March 2022, the Bank of Israel approved increasing the asset diversification of its FX reserves. Equities can now reach a maximum of 27% of total reserves, the combination of equities and corporate bonds 35%, and below-investment-grade corporate bonds 5%. Has the strategy been fully implemented?

We now have 23% invested in equity and 10% in corporate bonds. Overall, 33% in the combination of equity and corporate bonds. We don’t want to get to the limit, we must have some cushion because these markets are volatile. And it’s very difficult to manage a portfolio when you are close to the limits.

We are implementing a long-term strategic decision to gradually increase the investment in equity and corporate bonds given the high level of reserves that we have. When reserves were close to the adequate level, estimated to be between $70 billion and $110 billion, we didn’t want to risk taking them below it. Once we moved way above that level, we increased the investment horizon. Now, our reserves hover around $195 billion. That provides us with sufficient room. But we stick to our strategic approach. Almost exactly 10 years ago we started investing in equity with a 3% allocation. We deem this gradual method is a better strategy than trying to time the market.

The markets department has some flexibility to manage the reserves’ investment. In what way is this flexibility used? In which areas is this clearer?

So, first of all, the MPC delegates degrees of freedom to the department in all dimensions, duration, investment, proportion in equity, foreign exchange, currency positions. Of course, this is limited. But we can hold long and short positions against the benchmark equity allocation, and in duration, we can be longer than the MPC’s strategic portfolio, we can be shorter. We can be in different currency allocation relative to the portfolio. And we use this freedom in different levels. 

First, the dealing room has its own degree of flexibility to move from the portfolio. Then, the markets department has a greater freedom to move from the strategic asset allocation. And within the department we have the investment committee, with six members. We rotate the president and its members regularly. This body is important for us in the decision-making process because in case of discrepancy it holds votes.

More broadly, as is the case with diversification, the Bank of Israel’s decision-making process comes from the bottom up. The MPC has the role of assessing, accepting or rejecting these proposals to, for instance, increase the allocation to riskier assets, or expand the eligible asset classes we can invest in.

What problems have you encountered implementing diversification in 2022 in comparison to the previous decade?

Our reserves have grown considerably. We have become a relatively large participant in some markets. In particular after the MPC took the decision to expand currency diversification last year. In some cases it takes time to complete an asset reallocation. In contrast to a decade ago, we need to take this factor into consideration. We don’t want to unduly influence markets.

The ongoing post-pandemic inflationary shock has resolved the zero-lower-bound challenge limiting monetary policy. Has it also reduced reserves managers’ need to boost returns through exposure to riskier assets?

Not necessarily. First of all, one of our goals is to cover the cost of the reserves in local terms, and these have gone up. We build a portfolio that we hope will cover the financing cost of the reserves over the long term. Another important aspect to consider is that higher short-term interest rates allow us to take more risk, because we have a bigger cushion against losses. That’s why in this new environment we haven’t changed much our risk appetite even with tighter monetary policy around the world. It really depends on how you actually measure risk. If, for instance, you measure risk by CVAR [conditional value-at-risk], you could take more risk because of the cushion effect that I talked about before.²

Asset diversification has contributed to boost Bank of Israel’s reserves to new records. But in the year to February 2023 the portfolio’s value declined by over 5%, mostly due to falling equity prices. How do you assess market risks in 2023? How prepared is your framework to sustain heightened volatility going forward?

Our investment horizon is three to five years, we do take into account that in [the] short term we could face volatility in our performance. We do take into account that in some specific year, we may have losses, but in the medium term, we do believe that we can actually enjoy the risk premium implied in equity and in corporate bonds and other riskier assets. That’s why we try not to time the markets. We do have some local positions that we take long or short in equity. These are positions that we take within the department. But our long-term view is that equity will do better than bonds, and there is an equity premium that we want to reap in the mid-term.

If you look back in history, you can see that in a five-year horizon you have something around a 90% probability that a very well-diversified equity portfolio will beat any well-diversified bond portfolio. So that’s the way we look at it. We are aware that in the very short term, a one-year horizon, we might have losses. But I must say that we’re relatively optimistic this year.

By the end of 2021, US equities accounted for 12.5% of your total portfolio, while Japanese stocks just represented 1.3%, French 1.1%, German 0.9% or British 0.8%. Could the Fed’s tightening cycle contribute to a greater geographic diversification of your equity investments?

Our global equity allocation is passive. That’s the way we invest. We invest according to markets’ weight in the MSCI World Index of developed markets. That is our benchmark, regardless of developments in any single country. This is in our strategic asset allocation. It doesn’t mean necessarily that we don’t take positions within the market all the time.

This is part of the flexibility that we use to invest the portfolio. But at the end of the day, the US equity weight is higher, and will be higher than other markets. Given the size of our reserves, it would be very difficult for us to be in smaller markets and preserve a liquid and tradable position. This is also related to our goal of being price takers, not price makers. This is our philosophy when it comes to equity investment.

Also last year, the MPC broadened the currency benchmark from three currencies, the US dollar, euro and sterling, to seven. This now also includes the yen, the Australian dollar, the Canadian dollar and the renminbi. What is the aim of this currency diversification?

Our investment philosophy is based on diversification. We don’t put much on timing in the market, we don’t put much on selection. We do put a lot of weights on diversification. The main motivation in this step was to increase the diversification of the exchange risk in our portfolio versus the shekel. Because, as I said before, one of our targets is to try to cover the reserves’ cost in shekel terms. This is a long-term target. We tried to figure out the optimal diversification, which reduces dramatically the risks relative to having lower diversification with just three currencies. We found out that these seven currencies reduce the volatility of our portfolio’s returns in shekel terms. By the way, all these seven currencies have the status of reserve currencies. We did not adopt any risky, unknown or volatile asset.

In the new currency benchmark the euro’s allocation falls from 30.8% to 20%. The eurozone no longer records negative interest rates – to what extent does it make the euro a more attractive reserve currency?

The reduction in euro allocation is unrelated to negative rates or low yields in the eurozone over the last decade. As I said, it is exclusively linked to our strategy of diversification. We just aim to reduce volatility, fostering stable returns in shekel terms. This is one of our main targets. You have to consider that we do not change our portfolio’s currency composition very often. The last time that we did it was 15 years ago. And certainly, monetary policy cycles are not one of the factors we assess when making these decisions.

Overall, the global perspective on the euro has changed over time. If you had asked me about it three years ago, I might have given you a different answer. What … is indisputable is that the euro is a major currency. Alongside the USD, they are the two most important currencies globally. Will the euro become the dominant currency? That is another question. It is questionable. It has not reached that status, and it is clear to everybody that the USD retains that role. But it remains an important currency in our portfolio and will remain an important currency globally in the years to come.

Following the Russian invasion of Ukraine, the US and its allies imposed unprecedented sanctions on Bank of Russia’s FX reserves. Do you think it will have major consequences on reserve currencies, for instance, boosting alternatives such as the renminbi?

It depends on what central banks you refer to. Among Western central banks, I do not think any of these institutions is worried about sanctions. It is obvious that a small group of countries have come under US sanctions over the last years, and they may be concerned about the sanctions imposed on the Bank of Russia. Overall, I am doubtful sanctions will harm the US dollar’s central position as the main reserve currency.

Despite the losses recorded last year, the reserves portfolio stood at over $196 billion in February, this is 37.5% of Israel’s GDP. Is this a level you feel comfortable with to navigate the more unstable environment triggered by the pandemic and the Russian invasion of Ukraine?

We’re very comfortable with the level of the reserves. It doesn’t mean that we won’t intervene purchasing foreign exchange in the future. We have done it in the past for monetary policy purposes.³ But at the moment, the level is satisfactory. There is no need to reinforce this buffer.

Over the last decade the portfolio systematically outperformed the basic benchmark. In 2021, the three-year annual return reached 4.4%. To what extent has the accumulated success with diversification reinforced itself, building up a larger portfolio that requires a smaller share of reserves available in case of an emergency?

That’s the whole idea. The fact that our reserves are much higher than the adequate level of reserves allows us to adopt riskier assets, and to have more volatility in our portfolio. Initially, that was the main motivation for expanding the diversification of the portfolio.

Some central banks deal with high level of reserves splitting the portfolio in two tranches; the investment tranche and the liquidity tranche. After thorough internal deliberations we concluded this is not the best strategy for us. We prefer to implement diversification across the entire portfolio. We think this allows us to better expand diversification and safely adopt an asset such as equities. 

Why have you concluded that tranching is not suitable for your diversification strategy?

We’ve had long debates on this topic. And we got to the conclusion that it’s not the best idea. Summing it up, from a risk-return perspective, tranching the portfolio is suboptimal by definition. In terms of operational factors, it would lead to higher operational risk. In terms of reputational risk, it’s not very clear how the public would perceive such a strategy. It’s not an easy task to convince the public, politicians … that now that you hold a high level of reserves you are deciding to divide it to take more risks with one part of it. In any case, the investment tranche would involve billions of dollars in public resources. 

There are a lot of considerations to take into account. Structurally, this is a challenging question. You have the responsibility to manage a high level of reserves, but you do not have the authority to handle it like you would in a sovereign wealth fund. At the end of the day, we factored in all these elements and decided it was not the way forward for us. At least not in the near future. I’m not saying it is a wrong strategy, but it currently fails to offer a clear solution to us.

Over the last year there have been months when the portfolio has declined sharply, partly due to falling equity prices. Have you found it more difficult to report your results, or more generally communicate your decisions?

Of course, it’s challenging to communicate on the decisions you take to manage your reserves, especially when you face higher risks. Nonetheless, if you did not take any risk, you would also be facing scrutiny and criticism. If you have a relatively low performance, people will always compare you to pension funds or other portfolios. If you continue to have low returns, you can also incur in reputational risks. The communication challenge is a double-edged sword, in this area it will always be a challenge regardless of the risk level you implement or the market volatility you face. It’s the nature of the game.

Notes

1. On March 22, the Fed also increased rates by 25 basis points.

2. CVAR is a risk assessment measure that quantifies the amount of tail risk an investment portfolio has. CVAR is derived by taking a weighted average of the “extreme” losses in the tail of the distribution of possible returns, beyond the value-at-risk cut-off point.

3. For instance, in 2021, the Bank of Israel carried out FX purchases to limit the shekel’s appreciation against the US dollar and the euro. A stronger exchange rate was putting downward pressure on import prices at a time of below-target inflation.