(Bloomberg) -- The Bank of England’s aggressive push to clear its balance sheet of bonds is sending ripples through money markets, where the cost of obtaining sterling cash hit the highest in three years by several metrics.

Analysts have warned the central bank will need to halt its weekly bond sales later in the year, or risk undermining future efforts to loosen borrowing conditions. For now the BOE is pushing ahead: It’s selling the debt it bought to stimulate the economy during the pandemic — and sucking up excess cash from the market in the process. Officials didn’t signal a change in their quantitative tightening program in a press conference following Thursday’s rate decision.

The rate banks must offer to attract overnight deposits has risen to the highest relative to the BOE’s key rate since 2021, data compiled by Bloomberg show. The Uk central banks is also at odds with the European Central Bank and Federal Reserve, which are avoiding direct sales for now, highlighting the delicate task policy makers face as they wean banks off emergency stimulus. 

There’s added urgency in the UK, because the taxpayer foots the bill for holding on to the bonds. 

“Financial conditions are tightening and liquidity conditions have the potential to create increased short-term rate volatility,” said Derek Halpenny, a researcher at MUFG. “The shortage of cash and the potential upward pressure on rates would certainly be inconsistent with the MPC cutting rates.”

To be sure, no one is panicking just yet. The BOE has backstop facilities primed and ready for banks in need of cash amid heightened focus on the functioning of the market. Its short-term repo facility — which provides banks with cash in return for pledging gilts — saw record £13.6 billion usage Thursday.

The BOE’s Andrew Bailey and Dave Ramsden signaled they weren’t yet worried about increased use of the STR facility when asked about the impact of QT on banks’ liquidity at the central bank’s post-meeting press conference.

“The STR is doing its job,” said Ramsden, citing a drop in repo rates. “Moves in FX swaps were bringing different players into play and some month-end effects, so you had a whole set of things going on in this quite specialist area.”

But the higher money market rates — which influence trillions of pounds of financial contracts — could mute the BOE’s efforts when it eventually seeks to transmit looser policy through the economy.

With UK rate setters only due to revisit their bond-selling policy in September, here’s a look at some of the potential funding strains that could merge before then:

Shrinking Liquidity 

The BOE’s quantitative tightening and the early repayment of pandemic-era bank loans has gradually reduced the amount of spare cash in the economy to the lowest since 2021. 

Spread Tightening

SONIA, the sterling benchmark for unsecured lending, has been drifting higher. That’s tightened the spread between it and the BOE’s key rate to fewer than five basis points for the first time since 2021. While the recent moves are small, liquidity conditions could end up deteriorating “gradually, then suddenly,” Moyeen Islam, a rates strategist at Barclays, wrote in a note to clients. 

Lending Divergence

SONIA represents an average of interest rates that banks pay to borrow sterling overnight from other financial institutions and other institutional investors. Drilling down into the data, the 90th percentile of transactions — or those most willing to accept deposits — is diverging from the average. 

These cash-hungry banks paid as high as 5.24% compared with the 5.20% average. That’s as close as they’ve got to paying Bank Rate since the early months of the pandemic in 2020.

On the Radar

A BOE weekly funding facility — designed to act as a pressure release valve — has seen record rising usage from banks in search of liquidity in recent weeks. 

Rising Overnight Costs

The premium over the Bank Rate that investors pay to obtain cash on the repo market — as measured by the Repurchase Overnight Index Average, or RONIA — rose to a four-year high at the start of the month after accounting for quarter-end spikes. It remains well below the dash-for-cash spike which followed in the wake of the pandemic in 2020, but is another sign of the intensifying hunt for liquidity.

(Adds QT and STR context starting in second paragraph.)

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