Central banks occupy a unique position in financial markets: they are simultaneously the setter of the risk-free rate, the lender of last resort, the regulator of the banking system, and — increasingly since 2008 — direct participants in asset markets at scale. Understanding how they operate as market participants is essential for anyone in rates, FX, or credit.
Quantitative Easing: The Mechanics of Asset Purchases
Quantitative easing (QE) is the process by which a central bank creates new central bank reserves and uses them to purchase assets — typically government bonds, but in some programmes also corporate bonds, covered bonds, or asset-backed securities. The Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, and the Bank of Japan have all conducted large-scale QE programmes.
How the BoE Buys Gilts
The Bank of England's Asset Purchase Facility (APF) purchases gilts through reverse auctions. The Bank publishes an operation schedule in advance, specifying the maturity range and size of each operation. Primary dealers — the gilt-edged market makers (GEMMs) — submit offers into the operation, and the Bank accepts bids at the most competitive prices until the target size is reached. Settlement is typically next-day.
When the Bank purchases a gilt from a bank, it credits the bank's reserve account held at the Bank of England with new reserves. This is the "money creation" aspect of QE — central bank reserves are a form of money that only banks can hold. The bank that sold the gilt must now decide what to do with those reserves. The theory of portfolio rebalancing suggests that investors will seek to replace the sold gilts with other assets, pushing up prices across the yield curve and compressing yields.
At its peak in 2021, the Bank of England held over £895 billion of gilts and corporate bonds under the APF — equivalent to roughly 40% of GDP. The Fed's balance sheet peaked at around $9 trillion in 2022.
Repo as a Policy Tool
Repo markets are the primary transmission mechanism through which central bank policy rates are enforced. A central bank's policy rate — the Bank Rate in the UK, the Fed Funds rate in the US, the Main Refinancing Operations (MRO) rate in the eurozone — is operationalised through open market operations conducted in the repo market.
When a central bank wants to drain reserves from the banking system (for example, to push short-term rates up), it conducts reverse repos: it sells assets to banks with an agreement to buy them back, effectively borrowing cash from the banking system. When it wants to add reserves, it conducts repos: it buys assets from banks with an agreement to sell them back.
Standing facilities define the corridor around the policy rate. The BoE's Sterling Monetary Framework includes: the Bank Rate (the target overnight rate), the Standing Lending Facility at Bank Rate + a spread (the ceiling), and deposits at the Bank of England at Bank Rate (the floor). Commercial banks can always borrow at the ceiling or deposit at the floor, which constrains where overnight rates can trade.
FX Intervention
Central banks intervene in foreign exchange markets to influence the exchange rate. The motivations vary: maintaining a peg or band (as the Swiss National Bank did with EUR/CHF until 2015), smoothing disorderly market conditions, or managing external competitiveness (common among Asian central banks and the Bank of Japan).
Sterilised FX intervention involves the central bank buying or selling foreign currency while simultaneously conducting offsetting domestic money market operations, leaving the domestic money supply unchanged. Unsterilised intervention changes the monetary base and is a more powerful, but less common, tool.
The SNB's abandonment of the EUR/CHF 1.20 floor in January 2015 demonstrated the limits of intervention in the face of overwhelming market pressure. Having spent years buying euros and selling francs to hold the floor, the SNB was forced to abandon it as the expected ECB QE programme made the cost unsustainable. The franc appreciated by approximately 15–20% in minutes — one of the largest single-day moves in a G10 currency in modern history.
Impact on Pricing and Spreads
Central bank asset purchases have significant effects on market pricing across asset classes:
- Gilt yields: Large-scale gilt purchases compress yields directly by reducing available supply and indirectly through portfolio rebalancing. The Bank of England's QE programmes are estimated to have reduced gilt yields by 100–150 basis points cumulatively.
- Swap spreads: When the central bank buys large quantities of gilts, it can push gilt yields below swap rates (since swap rates are not directly purchased), compressing or even inverting the swap spread. This occurred notably in the UK in 2011–2012.
- Credit spreads: Portfolio rebalancing effects from QE push investors into riskier assets, compressing credit spreads. The ECB's corporate sector purchase programme (CSPP) had a direct effect on European investment-grade spreads from 2016 onwards.
- Repo markets: Central bank bond holdings can reduce the supply of high-quality collateral available for repo, pushing repo rates below the policy rate — a phenomenon known as "collateral scarcity."
Quantitative Tightening and Exit Strategy
Quantitative tightening (QT) is the process of reducing the central bank's asset holdings. This can be done passively — allowing bonds to mature without reinvesting the proceeds — or actively, through outright sales back into the secondary market. Active QT is more disruptive to markets and has been used cautiously. The Bank of England began active gilt sales in 2022 as part of its QT programme, with regular reverse auctions across the maturity spectrum.
The interaction between QT and the gilt market was dramatically illustrated in October 2022, when the BoE was forced to temporarily pause its QT sales and instead purchase long-dated gilts to restore order following the market disruption triggered by the UK government's "mini-budget." The episode showed that central bank gilt purchase and sale operations interact directly with leveraged positions in the gilt market — in this case, the liability-driven investment (LDI) strategies of defined benefit pension funds.
For traders and risk managers, QT has several practical implications: it increases net government bond supply, putting upward pressure on yields; it can tighten conditions in the repo market as collateral becomes less scarce; and it represents a reversal of the tailwind that compressed credit spreads during QE.