GBP Money Markets: High Premium For Terming Out

(MENAFN- ING) Term risk premium offers opportunities

Sterling money market rates have shown significant swings on the back of oil price moves, and we should brace for more volatility. For every $10 increase in oil prices, the 2yr gilt yield rises by around 15bp. With Brent oil at $100, markets are pricing in more than four hikes from the Bank of England over the coming year. This would bring SONIA to around 4.75%.

We think markets have turned too hawkish on the Bank of England and therefore see value further out the money market curve. Trading this market is difficult, however, as any further escalation in the Middle East would immediately push interest rates higher again. For this reason, we believe the curve embeds a significant risk premium for longer-maturity exposures.

Our economist does not expect the BoE to hike rates, and the central bank's communication is also more dovish than market pricing. Second-round inflation risks are limited, as the labour market has already cooled significantly over the past year. At 3.75%, we believe the policy rate is already restricting the economy, limiting the risk of overheating. As inflation should converge to target by mid-2027, we see scope for the BoE to cut rates towards 3.25%.

Markets are significantly more hawkish than economists Liquidity costs still to rise, but not immediately

Even though SONIA rates seem to have stabilised at 2bp below Bank Rate, we still think liquidity could become more expensive in future. Quantitative tightening continues to withdraw reserves from the system, and banks increasingly rely on the Bank of England's liquidity facilities. The Short-Term Repo (STR) facility, which provides one-week reserves, is priced at Bank Rate and requires high-quality collateral, mainly gilts. The pricing of the six-month Indexed Long-Term Repo (ILTR) facility is more complex and increases as demand for reserves rises.

SONIA has settled around 2bp below Bank Rate, but could still drift higher

When demand at the ILTR auctions exceeds £8bn, banks will have to pay more for their funding, increasing liquidity costs. In July, the maximum allocation was £7.4bn, close to the threshold. Below the threshold, the spread paid by banks is fixed between 3bp and 15bp, depending on the quality of collateral. Above the £8bn threshold, the Bank of England will charge higher spreads, although the exact calculation is not public. The maximum allocation is set at £35bn, which offers plenty of headroom for the coming years.

Reserves are more costly when demand for ILTR exceeds £8bn

The Bank of England expects the clearing spread for the lowest-quality collateral to settle around 20-40bp, well above the minimum spread of 15bp. In effect, this would increase overall liquidity costs in sterling markets. Consequently, SONIA could still drift higher, potentially above Bank Rate. That said, SONIA is an overnight rate, while the ILTR facility provides six-month liquidity. SONIA also focuses on wholesale deposits from non-banks and therefore captures a different market segment from banks with access to the BoE's facilities. As such, the pass-through will not be one-to-one.

The good news is that reserves remain ample and we are still far from a significant repricing of liquidity. Banks are unlikely to bid above the minimum clearing spreads for now, so allocations will likely remain capped at £8bn. Only once the allocation hits the threshold for multiple consecutive weeks would we start to anticipate a material drift higher in SONIA and other liquidity measures.

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