Money Markets and the Bank of England
The Bank of England is reducing its balance sheet, and this change is expected to cause some "bumps in the road" for money markets. According to Vicky Saporta, the BoE’s executive director for markets, these bumps are a natural part of the financial system adjusting to the new landscape.
The Reduction of the Balance Sheet
The Bank of England, like the US Federal Reserve and the European Central Bank, has been reducing the volume of assets on its balance sheet. These assets, mostly government bonds bought as part of quantitative easing from 2009 to 2021, peaked at over 40% of annual economic output in late 2021. They are now below 25%, which is broadly similar to the Fed, due to quantitative tightening and banks’ repayment of COVID-era loans.
The Impact on Banks
Banks want to hold between 375-540 billion pounds of reserves at the BoE, which is less than their current holdings of 630 billion pounds and a peak of nearly 1 trillion pounds in 2021. The upper level of this "preferred minimum range of reserves" could be reached late next year, based on the current pace of QT. However, it may take until mid-2027 if banks continue to increase their use of the BoE’s liquidity facilities.
Recent Market Volatility
There was a recent spike in overnight rates on the gilt repo market, which is used by financial market participants to borrow cash from each other using British government bonds as collateral. These rates rose more than 30 basis points above the BoE’s 4% Bank Rate, the largest such spike in over a decade, before returning to their normal spread of 5 bps. This upward move reflected large repayments of COVID loans by banks, the October month-end, the end of the Canadian financial year, and spillovers from the US repo market.
The Bank of England’s Response
The BoE’s repo facilities helped to reverse the move, with banks borrowing a record 97.8 billion pounds from the BoE’s weekly short-term repo. As long as spikes in repo rates do not threaten monetary or financial stability, the BoE sees these as a natural consequence of the financial system adjusting to the evolving liquidity landscape. The BoE is also reviewing the pricing of separate ad-hoc facilities, which allow banks to borrow from the BoE at shorter notice and at a higher rate.
Conclusion
In conclusion, the Bank of England’s reduction of its balance sheet is expected to cause some volatility in money markets. However, the BoE’s liquidity facilities are working well to smooth out these bumps, and the bank is closely monitoring the situation. As the financial system adjusts to the new landscape, it is likely that there will be more spikes in repo rates, but the BoE is ready to respond to ensure monetary and financial stability.
