Sovereign Wealth Funds ... Sexy?

There has indeed been much flurry recently on the sovereign wealth funds and their impact on financial markets. This is of course not because the SWFs represent a new thing in financial markets; in fact most of them have been around for quite some time save of course China's which has been created to managed at least a part of the increasing reserve accumulation of the Chinese central bank. On that note, the fact that the recent IPO by the US private equity group Blackstone was joined by China's SWF through a US 3 bn. stake caused much commotion. However, the main venue of discussion concerning SWFs concern their future impact on financial markets given estimations of their size in the future. Morgan Stanley's GEF for example suggest that already by 2015 the SWFs will be managing as much as US 12 bn. Regarding the impact on financial markets much of the commentaries have revolved around the SWFs impact on equity markets relative to markets for fixed income instruments (e.g. sovereign debt). As Steen Jakobsen points out in a recent note ...

Sovereign Wealth Funds, SWF, have 2.5 trln. USD under management according to Morgan Stanley report - same institution says the move FROM fixed income to equties will increase long-term yield by 30-40 bp.

Yet, as Steen also notes we need look at what is happening in the real world is this really what we can expect? Recently, I looked at financial markets in the context of ageing, an entry which inevitably discussed the impact of SWFs on financial markets in the future. Now, I want to make clear that when it comes to SWFs relative impact on bond yields there is ground for some pretty serious circular reasoning I think. As such, the traditional story goes something like the quote above suggests. The increase in the clout of SWFs will be a proxy for a move from fixed into equities which in turn will increase long term bond yield (perhaps solving the infamous conundrum?). This excerpt from a recent market.view column from the Economist is very much to the point in this respect ...

Equity markets are being buoyed both by strong profits and by the “private equity put”, the stream of bids for leading companies from the likes of Kohlberg Kravis Roberts and the Blackstone Group. Bond markets are being driven by the perception that Asian central banks (and others) may be tiring of their focus on government bonds and may be diversifying into other areas. (Witness China’s investment in Blackstone.) In 2005 Alan Greenspan famously posed the “conundrum”: why had long-term interest rates stayed flat when short-term rates were rising? The most common answer was to blame the Asian central banks; models suggested yields were around 50-100 basis points lower than they might otherwise have been because Asian banks were buying so many Treasury bonds. Some of that subsidy may now be dissipating.

Yet, We also need to remember that the very reason for the potential strong increase of SWFs' assets is the reserve accumulation by CBs itself which of course tend to push the other way in terms of long term bind yields. So you get it so far? There seems to be a two-way mechanism in effect and while I have no problem seeing that SWFs will be more prone to take risk in equity markets and even more sophisticated markets I am not sure that this will decisively push up long term yields since the very fact that the clout of SWFs is increasing signifies that reserve accumulation also continues. Add to this that I am more or less skeptic regarding the long term net supply of sovereing debt I don't see an unwind of the bond conundrum.

Lastly, I also want to note my immediate impetus for this entry which is Brad Setser's recent post on the same topic. He is also skeptical of the announced effect of SWFs, according to Brad reserve accumulation is still the story of the day. This is I think is an important point and also, incidentally, regarding the net supply of global sovereign debt ...

The only strong conclusion that I have been able to draw from looking at the asset allocation of existing sovereign wealth funds is that they, unlike central banks, don’t shy away from emerging markets.  But then again most emerging markets don’t need any more inflows.  The last thing Brazil – and a host of other countries –want is for China’s new investment fund to start to play the carry trade and add to the pressure on Brazil’s currency. The oil funds would love to invest in Asia, but what Asian country currently needs the money?  Almost all can finance their existing level of investment out of domestic savings.  India invests more than it saves, but it already is attracting more funds than it needs.

And also this is very important ...

If you assume that some existing central bank asset, which, counting all of the Saudi Monetary Agency's foreign assets, are now probably closer to $6 trillion than to $5.5 trillion, will be shifted to sovereign wealth funds, then sovereign wealth funds will get really big really fast.  

But for now, old-fashioned central bank reserves are still growing faster than sovereign wealth funds. Central banks just don’t seem to be buying Treasuries.  Not in April, when they sold Treasury bills to buy notes.

I mean, this is pivotal point. Can we really assume this and if so what will the net effect be in terms of demand from central banks towards sovereign debt?