Bank of England’s Bond Purchases Incurring Substantial Losses with Worsening Outlook in 2023.
The Bank of England (BOE) is grappling with significant losses on the bonds it purchased to support the U.K. economy in the aftermath of the financial crisis, and these losses are projected to escalate substantially in the coming years, as highlighted by Deutsche Bank.
In late July, the central bank had estimated that it might need the U.K. Treasury to provide a backstop for around £150 billion ($189 billion) in losses tied to its asset purchase facility (APF). This program, which was in operation from 2009 to 2022, aimed to enhance funding conditions for businesses impacted by the 2008 financial turmoil.
During this period, the BOE amassed an impressive £895 billion worth of bond holdings by taking advantage of historically low-interest rates.
Nonetheless, the BOE embarked on unwinding its position late last year. This initially entailed discontinuing the reinvestment of maturing assets and subsequently actively selling the bonds at a projected annual pace of £80 billion, starting from October 2022.
At the program’s inception, the Treasury and the BOE knew that the initial profits (£123.8 billion as of September of the previous year) would eventually give way to losses as interest rates climbed. However, the pace at which the central bank needed to tighten its monetary policy to combat inflation has led to higher costs than initially foreseen.
The surge in interest rates has driven down the value of the government bonds, known as gilts, which were purchased. This depreciation aligns with the BOE’s decision to sell them at a loss.
Notably, July’s latest public finance data indicated that the Treasury had transferred £14.3 billion during that month to the BOE to cover the losses incurred through its quantitative easing program. This figure is £5.4 billion higher than the independent Office for Budget Responsibility‘s (OBR) projection from March.
Deutsche Bank’s Senior Economist, Sanjay Raja, pointed out that a total of £30 billion has moved from the Treasury to the central bank since September, and these indemnities are likely to continue exceeding the government’s forecasts for two main reasons.
Firstly, interest rates have surged beyond the levels assumed in the fiscal watchdog’s spring predictions. Secondly, the prices of gilts have experienced a further decline, particularly in the longer-term portion of the curve. This has led to additional valuation losses as the BOE actively unwinds the APF by selling gilts.
Throughout 14 consecutive monetary policy meetings, the Bank of England has implemented a series of rate hikes, causing its benchmark interest rate to climb from 0.1% in late 2021 to a 15-year peak of 5.25%.
It’s widely anticipated in the market that a 15th hike, bringing the rate to 5.5%, will be announced at the next meeting of the Monetary Policy Committee. Facing a double-barreled impact, the Bank of England’s financial situation is coming under scrutiny.
Imogen Bachra, the head of U.K. rates strategy at NatWest, has highlighted the dual blow to public finances and the government’s revenue streams.
Bachra explained this complex issue in detail: The financial hit comprises two distinct aspects.
First, there’s the outcome of Quantitative Tightening (Q.T.), where the Treasury absorbs losses when the Bank of England (BoE) sells gilts lower than their purchase cost. This outcome was anticipated, given that the BoE acquired bonds with declining interest rates due to disinflation.
The success of this venture was predicated on a shift towards reflation and, subsequently, higher rates. Bachra elaborated on this matter in a recent note.
Second, while Quantitative Easing (Q.E.) gilts remain unsold, the BoE must pay the Bank Rate on the reserves, totaling approximately £900 billion, which it generated to purchase these gilts. As the Bank Rate climbs, the associated interest expense grows more burdensome.
This financial situation could affect the government’s capacity to fulfill commitments related to public spending or tax reductions, especially in the lead-up to the scheduled general election in 2024.
In analyzing the situation, Deutsche Bank examined the projected net interest expenses linked to central bank reserves and the declining value of the Asset Purchase Facility (AFP) bonds. The losses materialize when the BOE sells or redeems these bonds at “mark-to-market” prices.
Deutsche Bank’s Sanjay Raja concluded that over the next two fiscal years, the Treasury’s cost of repaying the central bank will likely surpass the forecast the Office for Budget Responsibility (OBR) made in March. This divergence is estimated to be approximately £23 billion, resulting in projected costs of £48.7 billion for the present fiscal year and £38.1 billion for the subsequent year.
However, these costs are predicted to decrease significantly in the next two years as the Bank Rate declines and the overall size of the AFP stock diminishes.
Raja pointed out that the situation has taken an unexpected turn due to higher inflation than initially anticipated. Consequently, the indemnity expenses associated with the Bank of England’s balance sheet operations are now projected to exceed expectations from just five months ago.
This extra financial burden, which impacts the government’s debt servicing expenditures, will be evident in the autumn budget statement by Finance Minister Jeremy Hunt.
Interestingly, there is a silver lining. Government revenues have experienced robust growth in recent months due to a strengthening economy. This upswing will likely lead to an overall borrowing figure that falls below the projections outlined by the OBR, which will help mask the increasing costs linked to the Bank’s Asset Purchase Facility bill.
In summary, the Bank of England’s financial challenges are multifaceted, with the dual impact of Quantitative Tightening losses and mounting interest expenses on central bank reserves.
These financial strains could affect the government’s ability to manage its fiscal commitments in the lead-up to the upcoming general election. However, despite the ballooning costs associated with the Asset Purchase Facility, the government’s more robust revenue stream from a growing economy may alleviate some of the immediate pressure.
