The UK became the focus of the fixed-income world in recent weeks, with the BOE buying £19 billion ($20 billion) of government bonds as surging yields forced pension funds into fire sales to meet margin calls on their derivatives positions. While most of the blame for the swiftness of the collapse in gilt prices in recent weeks lies with the government’s disastrous attempt to slash taxes, gilt yields were already rising: the BOE’s proposal to offload its bond holdings put it into direct competition with the burgeoning borrowing requirements of the state.
The impending withdrawal of liquidity supplied by the central bank triggered increased market friction, making it harder for investors to trade gilts. The BOE had to become the market-maker of last resort, albeit temporarily. But the episode underlines that taking away stimulus is tough, and suggests that simultaneously hiking interest rates and embarking on quantitative tightening could be a tricky proposition for any central bank seeking to reduce balance sheets that were swollen by the various pandemic support programs.
The Fed’s balance sheet reached $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 extra €2.3 trillion of assets and €1.5 trillion of commercial bank liquidity added since 2020. Central bankers, though, have been remarkably reticent to discuss the potential dangers of a twin tightening of monetary policy by simultaneously raising borrowing costs and unwinding bond purchases.
The Fed has tried twice with QT already, first in 2013 with a resultant so-called taper tantrum, and again in 2018 before Fed Chair Jerome Powell backed off. This time it has eased itself into unwinding its holdings, allowing $95 billion to passively run off through maturing Treasury bonds and mortgage-backed securities. Nevertheless, illiquidity in US government debt is becoming an increasing concern, as my colleagues have written here and here.
The Nov. 2 Fed meeting is likely to see a fourth consecutive 75 basis-point hike in official interest rates to 4% and signs of stress are already building in the money markets. The spread between overnight and three-month money in dollars, a key stress gauge during crises, has widened from near zero in September to 43 basis points now. The time value of money is getting more expensive as banks charge more to lend for longer to each other.
The ECB faces a similar dilemma as it raises borrowing costs at the same time as considering pulling its bond market stimulus. The tricky part for the euro zone is winding down its super-generous commercial bank liquidity package, known as Targeted Longer-Term Refinancing Operations. The bulk of this is scheduled to be repaid by June next year; but if the governing council goes ahead with a mooted plan to retrospectively to change the terms of the financing, banks could hand the loans back early, sapping financial liquidity. With Italian 10-year yields near 5% and hovering close to their peak premium of 250 basis points above benchmark German debt, the ECB will need to tread carefully.
All three of the world’s major central banks are keen to abandon the emergency bond-buying programs introduced during the global financial crisis and accelerated during the pandemic. But just as their combined efforts magnified the stimulus across the world, synchronized withdrawals risk triggering a global contraction of financial conditions. Money flows across borders like water; the BOE’s recent stop/start is a salutary lesson that policy makers need to heed.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.
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