The Bank of England is facing major losses on its bond purchases — and it's set to get much worse

Deutsche Bank has predicted that the Bank of England will suffer losses on its bonds purchased to support the U.K.'s economy "substantially higher than expected."

The Bank of England estimated in late July that the U.K. Treasury would be required to cover PS150 billion ($189.3 billion) of the losses on the Asset Purchase Facility (AFP) if the Bank of England were to fail.

Sanjay Raja, Senior Economist at Deutsche Bank, said that the Treasury's costs of compensating the AFP for losses in the two next fiscal years would be approximately PS23 billion more than what the OBR predicted in March.

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Bank of England

According to Deutsche Bank, the losses on bonds purchased to support the U.K.'s economy following the financial crisis are "substantially higher than projected by the middle of this decade."

In late July,

The central bank estimates

The U.K. Treasury would be required to cover losses of PS150 billion ($189 Billion) on its Asset Purchase Facility (APF).

The program, which ran from 2009 until 2022, was intended to improve the financing conditions for businesses affected by the 2008 financial crises. The BOE accumulated PS895 billion in bond holdings at a time when interest rates were historically low.

The central bank started unwinding this position in late 2018, first by halting the reinvestment of maturing assets, and then actively selling the bonds, at a projected rate of PS80 billion each year starting October 2022.

Treasury and BOE both knew that when the AFP program was introduced, its initial profits (PS123.8 Billion as of September last years) would turn into losses as interest rates increased.

The central bank's pace of action has been a concern.

Tightening monetary policy

In an effort to curb inflation, costs have increased more than expected. The BOE has begun selling the government bonds purchased at a loss as higher rates are driving down their value.

The data on July's public finance showed that the Treasury transferred PS14,3 billion to the Bank of England over the course of the month in order to cover losses on the quantitative easing program. This was PS5.4 billion more than the Office for Budget Responsibility had predicted in March.

Deutsche Bank

Sanjay Raja, Senior Economist at the Bank of England, noted that since September a total amount of PS30 billion had been transferred from the Treasury to central bank. The indemnities will likely continue to be well above government forecasts due to two factors.

First, interest rates are higher than the fiscal watchdog had predicted in its spring forecast. Second, gilt prices are down further, especially at the long end of the curve. This has led to further valuation losses, as the Bank unwinds APF by selling active gilts.

The Bank of England raised rates in 14 consecutive meetings of its monetary policy committee, bringing the benchmark interest rate to 0.1% by late 2021.

The rate of inflation has reached a record high for 15 years, at 5.25%

Markets expect a 15.5% hike at the next Monetary Policy Committee.

Two-fold hits

Imogen Bachra is the head of U.K. Rates Strategy at NatWest. She said that the impact on the public finances, and thus the government coffers, was twofold.

QT is losing money on the one hand because the Treasury absorbs the BoE's loss when gilts sold for less than they were paid. It was to be expected. The BoE purchased bonds at a time when rates were falling due to deflation. Success was defined as higher rates and reflation.

The BoE is paying Bank Rate for the reserves created by QE to purchase gilts, even though they are not being sold. This interest expense will become more expensive as Bank Rate increases.

This could hamper the ability of the government to make public spending pledges or reduce taxes ahead of an upcoming general election in 2024.

'Ballooning cost'

Deutsche Bank calculated both the likely net interest costs on the central bank reserves as well as the deteriorating values of the AFP Bonds when the BOE crystallizes "mark-to market" losses through the sale or redemption.

Raja concluded that Treasury costs for indemnifying central bank in the coming two fiscal years would be approximately PS23 billion more than what the OBR predicted in March. The cost will come in at PS48.7 Billion this fiscal year, and PS38.1 Billion next year. It then drops sharply over the following two fiscal years as Bank rates fall and the size of the AFP is reduced.

Not only inflation is running

Higher than expected

The BoE's operations on its balance sheet will almost certainly cost more than was anticipated only five months ago," Raja stated, adding that the additional burden placed on the government in terms of debt service will be reflected by Finance Minister Jeremy Hunt’s autumn budget announcement.

The good news is, despite the fact that government revenues are running much higher -- thanks to the stronger economy in the last few months -- the total borrowing will likely still undershoot OBR forecasts going into the autumn fiscal report. This will mask the ballooning costs of the Bank's bill for the APF.