Straight and narrow: recent changes in SONIA and why we care

SONIA is an important indicator of the effectiveness of the monetary policy stance and market conditions…

SONIA is the Sterling Overnight Index Average rate – the UK’s preferred ‘risk-free rate’ benchmark that measures average interest rates paid by banks on unsecured sterling overnight deposits from wholesale customers. The Bank has produced the (reformed) SONIA interest rate benchmark since April 2018.

SONIA is widely referenced in financial instruments across the economy and is a key tool in the transmission of monetary policy. It anchors short-term wholesale interest rates which are passed through to the wider economy via interest rates on loans, mortgages and other financial instruments. SONIA is also referenced in sterling OIS (Overnight Index Swap, a type of interest rate derivative contract), which can be used to infer market expectations of monetary policy developments. Therefore, changes in SONIA rates can indicate changes in market conditions, market sentiment, and overall stability.

…and the distance between Bank Rate and SONIA can reflect, among other things, the amount of liquidity in the system.

SONIA typically sits under Bank Rate^{footnote [1]} due to remuneration required by banks, as they seek to manage costs of taking SONIA deposits.

In times of abundant reserves, with a lot of cash in the system, banks tend to have little appetite to take deposits, leading to a downward pressure on the SONIA rate while volumes remained robust. Similarly other money market rates also tend to be lower due to less competition for a larger supply of reserves.

At the peak of quantitative easing in 2022, when sterling reserves were at their highest, SONIA was around 5.5 basis points below Bank Rate. SONIA moved further away from Bank Rate during the period of severe market dysfunction in late 2022 reaching 7.4 basis points (Chart 1). Since then, we have seen the spread gradually compressing.

Chart 1: SONIA and percentiles as spread to Bank Rate ^(a)

Footnotes

• Source: Bank of England.
• (a) On 19 March 2020 SONIA was 11.34 basis points above Bank Rate. The scale on the y-axis limits the display at the 10th and 90th percentile, meaning some data points are beyond the axis.

Sterling reserves have been steadily declining due to quantitative tightening (unwinding Asset Purchase Facility purchases) and repayments of the Term Funding Scheme with additional incentives for SMEs, creating greater competition for reserves. This was indeed seen in average repo rates increasing (alongside other factors such as increasing collateral),footnote [2] albeit remaining anchored close to Bank Rate, but SONIA has resisted the trend until recently (Chart 2).

With falling reserves and increasing rates in repo markets, depositors in overnight unsecured markets have been able to demand a higher rate of return on their deposits and so rates in unsecured markets have started ticking up. The SONIA to Bank Rate wedge has recently narrowed to just over 3 basis points.

Chart 2: SONIA rate and repo rate as spread to Bank Rate ^(a)

Footnotes

• Sources: Bank of England, Sterling Money Markets Data and Bank calculations.
• (a) On 19 March 2020 SONIA was 11.34 basis points above Bank Rate, while on 16 December 2021 the rate was 8.78 basis points below Bank Rate.

The Bank introduced quantitative easing in March 2009 at the same time ending the reserves averaging framework. Caution is necessary if trying to draw comparisons between the wedge now and pre-2009 due to significant differences between the operating frameworks and market dynamics. Current levels of reserves are still significantly higher than in 2018, when reserves sat within the range of where we now estimate precautionary and transactional demand – referred to as the Preferred Minimum Range of Reserves (PMRR).footnote [3] But again, it is difficult to draw conclusions given the differences in SONIA methodology.

Chart 3: SONIA – Bank Rate wedge and sterling reserves ^{(a) (b)} (April 2018 to date)

Footnotes

• Sources: Bank of England and Bank calculations.
• (a) Based on weekly data on reserves.
• (b) Weekly frequency was used for the SONIA rate data, to correspond to the weekly reserves data. On 19 March 2020 SONIA was 11.34 basis points above Bank Rate, this data point is not captured in weekly frequency.

Chart 4: SONIA – Bank Rate wedge and sterling reserves ^{(a) (b)}

Footnotes

• Sources: Bank of England and Bank calculations.
• (a) Chart uses weekly reserves data.
• (b) During the reserves averaging period, SONIA exhibited significant day-to-day volatility, ranging from 136 basis points below to 97 basis points above Bank Rate. The SONIA-Bank Rate wedge axis is fixed, limiting visibility of the full range of data points.

While ordinarily reserves draining could lead to higher money market rates, the Bank’s Sterling Monetary Framework facilities, the Short-Term Repo (STR) and Indexed Long-Term Repo in particular, are acting as a backstop, on averagefootnote [4] keeping repo rates close to Bank Rate albeit with a positive spread (How is the transition to a repo-led framework progressing?). At present, the effective ‘cap’ on repo rates, together with the cost versus profitability of unsecured funding, is in turn effectively placing an upper bound on how close to Bank Rate unsecured rates may move. SONIA deposit takers continue to protect their margin earned on cash. Further to this, considering operational frictions and opportunity costs, capped repo rates may disincentivise some participants from pivoting from unsecured market to repo. Operational frictions can be prohibitive when switching between secured and unsecured markets. If repo rates were to increase further, then the opportunity for yield enhancement could persuade some participants to move activity to repo to exploit the arbitrage opportunity. There is some compensation afforded to unsecured investors where stability and consistency is valued.

And while unsecured spreads may compress a little further as market participants adjust to new levels of reserves, we expect that the compression should be modest. That said, the balance sheet normalisation process is charting previously uncharted territory. As Victoria Saporta said in her speech, we are ‘learning by doing’ and so where SONIA goes from here remains to be seen.

This post was prepared with the help of Joanna McLafferty, Ashley Young, Kirstine McMillan, Callum Ashworth and Abhilash Barman.

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