TLDR:
- Global asset prices remain stretched and vulnerable to sharp corrections
- Geopolitical risks and global economic uncertainty are major concerns
- Hedge funds’ large short positions in US Treasuries pose potential risks
- Most UK households and businesses are coping with high interest rates
- The Bank of England is keeping its counter-cyclical capital buffer unchanged
The Bank of England (BoE) has issued a cautionary statement regarding the current state of global financial markets, highlighting concerns about stretched asset valuations and heightened geopolitical risks.
In its latest quarterly assessment, the central bank’s Financial Policy Committee (FPC) emphasized that while overall risks to British financial stability remain unchanged since June, investors should be prepared for potential market corrections.
According to the BoE, asset prices across several classes, particularly equities, quickly rebounded to stretched levels following a brief market sell-off in August.
This rapid recovery was attributed to stronger macroeconomic data, but the central bank warned that such positive outcomes should not be taken for granted in future episodes of market stress.
The FPC pointed out that global vulnerabilities remain significant, with uncertainty surrounding the geopolitical environment and global economic outlook.
A survey of major financial firms operating in Britain revealed that concerns about geopolitical risk have risen to their highest level since the survey began in 2008. While specific sources of geopolitical risk were not detailed, ongoing conflicts in the Middle East and Ukraine, as well as the upcoming U.S. presidential election, are likely contributing factors.
One area of particular concern highlighted by the BoE is the U.S. Treasury market. The central bank noted that hedge funds’ net short position in U.S. government bonds has increased to $1 trillion from $875 billion since June.
This substantial position could lead to severe market stresses if funds need to unwind these positions due to changed risk perceptions, losses, or other factors.
The BoE also addressed the issue of high public debt levels across major economies, suggesting that this could trigger financial stability risks if investors adopt a more pessimistic view of government borrowing. In the UK, public debt has risen to 100% of national income, which is mid-range compared to other advanced economies.
Turning to the domestic situation, the BoE reported that most UK households and businesses are managing well with high interest rates.
However, some pockets of difficulty exist, particularly among small businesses and those backed by private equity investors.
The central bank noted that recent interest rate cuts have eased the pressure on mortgage costs for households with expiring fixed-rate mortgages.
The BoE’s main interest rate currently stands at 5%, down from a 16-year high of 5.25% in August. Financial markets are pricing in a high probability of a further cut to 4.75% at the next meeting on November 7.
Looking ahead, the BoE forecasts modest economic growth for the UK in the second half of 2024, with an expected increase of 0.3% per quarter. This follows a shallow recession in late 2023 and a subsequent recovery in the first half of 2024.
The FPC has decided to maintain the counter-cyclical capital buffer at 2%, a tool used to manage risks in banks’ credit cycles. This decision suggests that the BoE believes the current level of capital held by banks is appropriate given the current economic conditions and potential risks.
