The Bank of England is grappling with substantial losses on bonds purchased to bolster the UK economy following the financial crisis, with these losses projected to exceed expectations until the mid-decade, warns Deutsche Bank. In a surprising turn, the central bank’s estimated losses necessitating support from the UK Treasury to the tune of £150 billion ($189 billion) for its asset purchase facility (APF) are notably higher than initially anticipated.
The APF initiative, active from 2009 to 2022, aimed to enhance funding conditions for businesses affected by the 2008 financial downturn. During this period, the Bank of England accrued an impressive £895 billion in bond assets while interest rates remained historically low. The process of unwinding these holdings commenced last year, initially by halting reinvestments of maturing assets, followed by the active sale of bonds at an estimated rate of £80 billion per year starting October 2022.
Even though both the Treasury and the Bank of England were aware that the early profits (£123.8 billion as of September the prior year) from the AFP would eventually transform into losses due to rising interest rates, the pace of monetary policy tightening to curb inflation has outpaced expectations. This accelerated rise in costs is attributed to higher interest rates driving down the value of government bonds (referred to as gilts), just as the BOE initiates their sale, resulting in a deficit.
Deutsche Bank’s Senior Economist Sanjay Raja highlights that a staggering £30 billion has been transferred from the Treasury to the central bank since September. This trend is likely to continue, mainly because interest rates have exceeded assumptions made in the fiscal watchdog’s forecasts and the declining prices of gilts have exacerbated valuation losses. These complexities have led the Bank of England to implement 14 consecutive rate hikes, pushing the benchmark interest rate from 0.1% in late 2021 to an unprecedented 15-year high of 5.25%, with expectations of a further hike to 5.5% in the next Monetary Policy Committee meeting.
The financial impact is twofold, as Imogen Bachra from NatWest points out. On one hand, losses stem from gilts being sold at a lower price than their purchase cost, a scenario expected due to the initial purchase in a declining rate environment. On the other hand, the BOE incurs costs due to the Bank Rate paid on the approximately £900 billion reserves created for the purchase of these bonds. This increased Bank Rate translates to higher interest expenses. These financial challenges could impede the government’s ability to promise public spending or tax reductions ahead of the upcoming general election scheduled for 2024.
Deutsche Bank’s assessment indicates that the cost of indemnifying the central bank by the Treasury over the next two fiscal years is projected to surpass expectations, amounting to £48.7 billion for the current fiscal year and £38.1 billion for the following year. However, this cost is predicted to decline over the subsequent two years as the Bank rate falls and the overall size of the AFP stock decreases. This unforeseen financial burden may influence Finance Minister Jeremy Hunt’s autumn budget statement. Despite these challenges, the optimistic note remains that government revenues, bolstered by a stronger economy, might offset some of these costs, potentially masking the burgeoning expense of the Bank’s APF bill.
