By Paul Hannon
Doubts among investors about the sustainability of rising government debt could push global borrowing costs higher and cause volatility in financial markets, the Bank of England warned Friday.
In its twice-yearly report on the soundness of the financial system, the BOE also said that stress tests showed the U.K. banking system could survive a severe global economic downturn. A test of the system as a whole found it to be in better shape than when a surprise package of large tax cuts caused turmoil in the government-bond market in late 2022.
Yields on U.S. government bonds rose in the run up to and in the immediate aftermath of the presidential election as investors worried about the prospect of bigger budget imbalances in the second Donald Trump administration. They have fallen over recent days, partly in response to the appointment of hedge-fund manager Scott Bessent to lead the Treasury Department.
But there are also new concerns about government borrowing in France and the U.K.
"A deterioration in market perceptions around the sustainability of the long-term path of public debt globally may lead to higher rates, increased term premia and market volatility," the BOE said.
Should prices of government bonds fall and yields rise, borrowing for households and businesses would also become more expensive. The BOE said if foreign investors became concerned about government-debt levels, they could withdraw their funds, leading to increased volatility of foreign-exchange and other markets.
The central bank repeated its view that investors haven't fully accounted for these and other risks, and that equities and corporate bond markets in particular are "vulnerable to a sharp correction."
Referring to big swings in U.K. bond prices in late 2022, Gov. Andrew Bailey said the BOE is keenly aware of how volatile the market for government bonds can be.
"Sovereign bond markets can move around very quickly and you have to be ready to respond to that," he said in a news conference.
Hedge funds could be particularly vulnerable to a jump in rates, the BOE said, citing an increase in their borrowing to levels that are high by historic standards.
The BOE said other global risks have also increased, including those posed by 'fragmentation,' or the breakup of the world economy into groups of allied countries determined to reduce their engagement with perceived enemies.
One consequence of fragmentation could be increased vulnerability to global financial setbacks, the bank said.
"A reduction in the degree of international policy cooperation could hinder progress by authorities in improving the resilience of the financial system and its ability to absorb future shocks," it said.
Bailey said it is "too soon to judge" how willing the new U.S. administration will be to support continuing work to set and maintain global financial rules, since important appointments have yet to be announced.
But he said those rules are key to ensuring that there is a level playing field competition between banks and other financial institutions.
"We have these international standards not just as an obsession with regulations, but because it is the basis of competitiveness," he said.
While the global outlook has become more uncertain and riskier, the BOE said the resilience of the U.K.'s financial system has improved. A recent stress test that assumed a sharp drop in global economic activity suggested banks would still have enough capital in aggregate to continue to lend to businesses and households, the BOE said.
The BOE also announced the results of a stress test of the financial system as a whole that was prompted by a rout in British government bonds, or gilts, after the announcement in September 2022 of surprise tax cuts by then-Prime Minister Liz Truss.
The test found the system had become more resilient to shocks, largely because the liability-driven investment funds that were at the center of the financial turbulence have reduced their borrowing, while money market funds have bigger liquidity buffers.
However, the stress test revealed a need to boost resilience in the repo market, and it also detected a risk that the market for corporate bonds could seize up, with a rush of sellers meeting a dearth of buyers.
Write to Paul Hannon at paul.hannon@wsj.com
(END) Dow Jones Newswires
11-29-24 0745ET
