The Bank of England is the central bank’s crash test dummy
The UK has become the focus of the fixed income world in recent weeks, with the BOE buying £19bn ($20bn) worth of government bonds as yields soar forced pension funds to sell on fire to meet margin calls on their derivatives positions. While most of the blame for the rapid collapse in gilt prices over the past few weeks lies with the government’s disastrous attempt to cut taxes, gilt yields were already on the rise: the BOE proposal offloading its bond holdings put it in direct competition with the burgeoning borrowing requirements of the state.
The impending withdrawal of central bank-provided liquidity has triggered increased friction in the market, making it more difficult for investors to trade gilts. The BOE was to become the market maker of last resort, albeit temporarily. But the episode underscores the difficulty of removing stimulus and suggests that simultaneously raising interest rates and initiating quantitative tightening could be a tricky proposition for any central bank looking to shrink balance sheets that have been inflated by the various pandemic support programs.
The Fed’s balance sheet hit $9 trillion this spring, more than double its pre-pandemic level. The ECB’s total assets are of a similar magnitude at €8.8 trillion ($8.6 trillion), with an additional €2.3 trillion in assets and €1.5 trillion in commercial bank liquidity added since 2020. Central bankers, however, have been remarkably reluctant to discuss the potential dangers of a double-tight monetary policy by simultaneously raising borrowing costs and canceling bond purchases.
The Fed has already tried twice with QT, first in 2013 with a so-called ensuing tantrum, and again in 2018 before Fed Chairman Jerome Powell backed down. This time, it eased into unwinding its holdings, allowing $95 billion to flow passively through maturing Treasury bonds and mortgage-backed securities. Nevertheless, the illiquidity of US public debt is becoming a growing concern, as my colleagues have written here and here.
The November 2 Fed meeting is expected to see a fourth consecutive 75 basis point hike in official interest rates to 4% and signs of strain are already showing in money markets. The spread between overnight money and three-month dollar money, a key stress indicator during crises, has widened from near zero in September to 43 basis points now. The time value of money is becoming more expensive as banks charge more to lend to each other longer.
The ECB faces a similar dilemma as it raises borrowing costs while considering withdrawing its stimulus from the bond market. The tricky part for the euro zone is the end of its super-generous liquidity package for commercial banks, known as targeted longer-term refinancing operations. Most of this sum is expected to be repaid by June next year; but if the board of governors goes ahead with a mooted plan to retrospectively change the terms of funding, banks could return loans sooner, undermining financial liquidity. With Italian 10-year yields close to 5% and close to their maximum premium of 250 basis points above benchmark German debt, the ECB will need to tread carefully.
The world’s three major central banks want to scrap emergency bond-buying programs introduced during the global financial crisis and accelerated during the pandemic. But just as their combined efforts amplified the stimulus across the world, the synchronized drawdowns risk triggering a global contraction in financial conditions. Money crosses borders like water; The recent stop/start of the BOE is a salutary lesson that policymakers should heed.
More from Bloomberg Opinion:
• BOE must make Halloween less scary: Marcus Ashworth
• Why breaking the QE addiction is such a struggle: Daniel Moss
• Even with Truss Gone, its U-turn will still compress households: Andrea Felsted
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Market Strategist for Haitong Securities in London.
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