Bank of England warns of credit crunch threat to economy

Stretched valuations have left global financial markets vulnerable to a violent sell-off that could cause a credit crunch for British households and companies, the Bank of England has warned.
In its first update since equities were gripped by a heavy but relatively brief bout of selling in August, the Bank’s financial policy committee cautioned on Wednesday that markets were “susceptible” to a much worse and more widespread rout. Such a crisis could have implications for the real economy by impacting “the cost and availability of credit to UK households and businesses”.
Stock markets fell sharply two months ago when investors took fright at disappointing results from America’s leading technology companies and unexpectedly weak US labour market data, raising concerns over the likelihood of a recession. The sell-off was exacerbated by the sudden unwinding of a popular trade involving the yen, which hit Japanese stocks and further rattled investors.
While markets quickly stabilised in August, the warning from the committee, which is responsible for assessing financial stability risks to the UK, suggested investors should not take false comfort from the limited fallout from the sell-off, not least because asset prices still appeared to be detached from reality.
“Valuations across several asset classes, particularly equities, quickly returned to stretched levels following the episode,” the committee said in its latest quarterly report.
It cautioned that “measures of equity risk premia [were] close to historical lows in the US, EU, and UK” even after the August turmoil. It said that market contacts had “noted the apparent disconnect between stretched valuations and risks to global growth, as well as the degree of sensitivity to short-term news”. This meant that markets “remained susceptible to a sharp correction”.
The warning came as intensifying conflict in the Middle East fuelled nervousness among investors, who are trying to second-guess the pace at which central bankers in the UK, the United States and elsewhere will cut interest rates.
Rampant inflation that began in 2021 forced policymakers to rapidly lift borrowing costs to contain price rises in the economy. Inflation has since fallen back, however, allowing central banks from the UK to Europe and Canada to start cutting rates in the summer.
Disappointing American job market data was one cause of the August sell-off because it raised fears among investors that the US economy was in a worse state than expected and that the US Federal Reserve had erred when it decided against cutting rates at the end of July. The Fed subsequently lowered its benchmark rate by half a percentage point last month.
A broader crisis did not develop during the rout two months ago because, although “there was evidence that investor deleveraging had amplified price moves, it did not spill over or materially affect the functioning of core markets”, the committee said. “It might have done so if subsequent economic news had not been positive or deleveraging had been more significant or broad-based.”
Despite the committee warning of “significant financial market and global vulnerabilities”, which include “high public debt levels in major economies [it judged that] the UK banking system remains in a strong position to support households and businesses, even if economic and financial conditions were substantially worse than expected”. As a result, it left the so-called countercyclical capital buffer, which is a rainy-day cushion that British commercial lenders are required to hold, at 2 per cent.
The committee also said it would examine more closely the potential financial stability risks posed by artificial intelligence and would report back in the first half of next year.
The threat to financial stability posed by hedge funds placing risky leveraged bets against US government debt has risen after companies amassed trades worth a record $1 trillion, according to the Bank of England (Ben Martin writes).
The net short position in US treasuries futures built up by hedge funds has surpassed its previous peak of $875 billion and could “amplify the transmission of a future stress” if markets are thrown into turmoil, the central bank’s financial policy committee said. Officials cautioned that “it was important for financial institutions to be prepared for such severe but plausible stresses”.
Short-selling is a technique used by some investors to speculate on, and profit from, falling prices in markets. Hedge funds’ shorting of treasuries pits them against traditional asset management firms, which are taking the other side of the trade by building long positions.
Markets were gripped by a sell-off in early August but the rout did not cause chaos in the wider financial system partly because the volatility did not force hedge funds that are betting against treasuries to unwind their trades en masse, the committee said. However, officials said that “vulnerabilities associated with this trade remained”.
Millions of households are set to feel slightly less pressure from higher mortgage costs after the Bank of England began to cut interest rates from a 16-year high.
About a fifth of borrowers, equivalent to around 1.7 million households, are on floating rate deals that are tied to movements in the UK’s base rate, the Bank’s financial policy committee estimated on Wednesday.
It said that these homeowners will have already begun to benefit from lower costs after the Bank reduced its benchmark rate from 5.25 per cent to 5 per cent in August, which is estimated to have trimmed almost £120 from annual payments made by borrowers on variable rates.
Around a third of mortgagors, or some 3 million borrowers, who are presently mainly paying interest of less than 3 per cent because they took out fixed deals when rates were much cheaper, are yet to remortgage but will do so by the end of 2027.
While they still face the shock of higher repayments, the hit to their budgets is now set to be smaller than it would have been had they been forced to refinance before the Bank began to cut its base. About 1.4 million borrowers who are due to remortgage in the next 12 months had earlier this year been on course to see their monthly loan costs rise by an average of £180. This increase has now fallen to an estimated £150.
“Overall, mortgagors continued to be resilient to higher interest rates, although some lower income households and renters remained under pressure,” the committee said in its report.
Policymakers still expect the so-called aggregate household mortgage debt-service ratio, a closely-watched measure of borrowers’ ability to service their debts, to rise. However, the gauge will “remain well below 1990s and global financial crisis peaks,” the Bank predicted.
It also expects the proportion of households spending more than 70 per cent of their post-tax income on mortgages and other essentials to stay “well below” the heights that were reached before the 2007-9 crisis.
In a further sign of households’ resilience, mortgage arrears and late payments on consumer credit were “largely unchanged” compared with the committee’s last update in June and were judged to be low by historical standards.
Borrowers have been under pressure ever since the Bank started to rapidly lift its base rate from a record low of 0.1 per cent in late 2021 to combat spiralling price rises in the economy. However, inflation, which peaked at a 41-year high of 11.1 per cent in October 2022, fell back to the Bank’s target of 2 per cent in May, paving the way for Threadneedle Street to start cutting rates.