Bank of England warns of increased risk of sharp market correction

Investing.com -- The Bank of England’s Financial Policy Committee (FPC) has warned that the risk of a sharp market correction has increased, according to the record of its October 2 meeting released Wednesday.

The committee highlighted that risks associated with geopolitical tensions, global fragmentation of trade and financial markets, and pressures on sovereign debt markets remain elevated. Any crystallization of these global risks could significantly impact the UK as an open economy and global financial center.

Despite ongoing uncertainty around the global economic outlook, the FPC noted that risky asset valuations have increased and credit spreads have compressed since its last meeting in June. The committee specifically pointed to stretched equity market valuations, particularly for technology companies focused on Artificial Intelligence (AI).

The combination of high valuations and increasing concentration within market indices leaves equity markets "particularly exposed should expectations around the impact of AI become less optimistic," the FPC stated.

The committee also highlighted recent credit defaults in the US automotive sector, which underscore previously identified risks around high leverage, weak underwriting standards, opacity, and complex structures.

Term premia in sovereign bond markets have increased in many advanced economies, driven partly by expectations of higher debt issuance. Political uncertainty in countries like France and Japan regarding fiscal reforms has increased the vulnerability of sovereign debt markets and reduced governments’ capacity to respond to shocks.

The FPC expressed concern about continued commentary regarding Federal Reserve independence in the US. The committee emphasized that central bank operational independence underpins monetary and financial stability, lowering borrowing costs for households and businesses.

"A sudden or significant change in perceptions of Federal Reserve credibility could result in a sharp re-pricing of US dollar assets, including in US sovereign debt markets, with the potential for increased volatility, risk premia, and global spillovers," the record stated.

On domestic matters, the FPC judged that UK households and corporations have remained resilient but face continued pressure from higher living costs and the adjustment to higher borrowing costs.

Despite these concerns, the committee maintained its judgment that the UK banking system has the capacity to support households and businesses even under substantially worse economic and financial conditions than expected.

The FPC decided to maintain the UK countercyclical capital buffer rate at 2%.