The Bank of England has issued a warning that stretched valuations have heightened the vulnerability of global financial markets to a significant sell-off, potentially triggering a credit crunch for households and businesses in the UK.

In its latest update following a brief but intense period of selling in August, the bank’s financial policy committee advised on Wednesday that markets remain “susceptible” to a more severe and widespread downturn. Such turmoil could adversely affect the real economy by influencing “the cost and availability of credit for UK households and businesses”.

The sharp decline in stock markets two months ago was spurred by disappointing quarterly earnings from major U.S. tech firms and unexpectedly weak job market data in the U.S., leading to recession concerns. A rapid unwinding of popular trades involving the yen also destabilized Japanese stocks, further alarming investors.

Despite a swift recovery in August, the committee’s warning suggests that investors should not feel overly reassured by the brief downturn, particularly as asset valuations continue to seem inflated.

“Valuations across multiple asset classes, especially equities, quickly returned to stretched levels following the episode,” the committee noted in its recent quarterly report.

The report highlighted that measures of equity risk premia remain “close to historical lows in the US, EU, and UK”, even post-August turmoil. It emphasized that market participants have observed a disconnect between inflated valuations and global growth risks, alongside a pronounced sensitivity to short-term news. Therefore, markets “remain vulnerable to a sharp correction”.

This warning occurs amid increasing investor anxiety due to escalating conflict in the Middle East, as they attempt to anticipate the timing of interest rate cuts by central banks in the UK, U.S., and elsewhere.

Persistently high inflation, which began in 2021, prompted swift rate hikes by policymakers to mitigate rising prices. However, inflation has since receded, enabling central banks in the UK, Europe, and Canada to initiate rate reductions over the summer.

Disappointing job market statistics contributed to the sell-off in August, as investors expressed concern that the U.S. economy may be struggling more than anticipated, leading to musings about the U.S. Federal Reserve’s decision not to cut rates at the end of July. The Fed later decided to lower its benchmark rate by half a percentage point last month.

A broader crisis did not arise during the sell-off because, while there was evidence that investor deleveraging amplified price movements, it did not significantly impact core market operations. The committee noted, “It might have escalated if subsequent economic news had been negative or if deleveraging had been more extensive or widespread.”

Though the committee indicated “significant vulnerabilities in financial markets and globally”—including “high public debt levels in major economies”—it assessed that the UK banking system is positioned adequately to support households and businesses, even under worse economic conditions than anticipated. Consequently, it maintained the countercyclical capital buffer at 2 percent.

Additionally, the committee plans to closely scrutinize potential financial stability risks linked to artificial intelligence and anticipates providing insights in the first half of next year.

Hedge Funds’ Record $1 Trillion Short in U.S. Debt Heightens Stability Concerns

The Bank of England has raised alarms about the financial stability risks from hedge funds engaging in risky leveraged bets against U.S. government debt, with their trades now exceeding a staggering $1 trillion.

The net short position in U.S. treasuries futures, amassed by hedge funds, has surpassed its previous peak of $875 billion. The committee stated this situation could potentially “amplify the transmission of future market stress” if conditions deteriorate.

Short-selling allows investors to profit from declining prices in markets, and hedge funds’ positions are countered by traditional asset management firms that are securing long positions.

Despite the early August sell-off, the broader financial system remained stable, in part because the volatility did not compel hedge funds betting against treasuries to liquidate their positions en masse. Nevertheless, the committee cautioned that the “vulnerabilities linked to this trade still persist”.

Mortgage Costs Decline for Millions of Households

Millions of households are set to experience some relief from soaring mortgage expenses as the Bank of England initiates interest rate cuts from a 16-year peak.

Roughly one-fifth of borrowers, or about 1.7 million households, are on variable rate deals tied to movements in the UK’s base rate. The committee estimates that these homeowners have already begun to see lower costs following a reduction in the benchmark rate from 5.25 percent to 5 percent in August, which has cut nearly £120 from their annual payments.

About a third of mortgage holders, or approximately 3 million borrowers, currently benefiting from interest rates below 3 percent due to fixed-rate deals taken out earlier, are not yet due to refinance but are expected to do so by the end of 2027.

Although they may confront the shock of renewed higher repayments, the impact on their budgets is projected to be less daunting than it would have been if they had to refinance earlier. Approximately 1.4 million borrowers set to remortgage in the next year were initially projected to see monthly payments rise by an average of £180, but this figure has now decreased to an estimated £150.

“Overall, mortgagors are demonstrating resilience in the face of higher interest rates, although some lower-income households and renters continue to feel pressure,” the committee indicated in its report.

Policymakers still expect the aggregate household mortgage debt-service ratio—an important measure of borrowers’ capacity to manage their debts—to rise, yet the Bank anticipates this will “remain well below the peaks witnessed during the 1990s and the global financial crisis.”

Furthermore, the proportion of households allocating more than 70 percent of their post-tax income towards mortgages and essential expenditures is expected to remain “well below” the levels observed before the 2007-09 crisis.

In another indication of household resilience, mortgage arrears and late payments on consumer credit remained “largely unchanged” since the committee’s last review in June and are considered low by historical measures.

Borrowers have experienced increased pressure since the Bank initiated significant rate hikes from a historic low of 0.1 percent in late 2021 to tackle rising inflation, which peaked at 11.1 percent in October 2022. However, the inflation rate has subsequently dropped to the Bank’s target of 2 percent as of May, thus facilitating a return to rate cuts.