The Bank of England (BoE) has warned that markets could “correct sharply” if traders start to worry about economic growth prospects from COVID-19, inflation or interest rates.
On Friday, the BoE’s Financial Policy Committee (FPC) said risk-taking remained elevated in a number of financial markets, relative to historic levels.
Stock indexes have climbed to record highs this year amid hopes for a strong recovery after the pandemic, but inflation concerns are growing thanks to supply chain disruptions, bottlenecks and surging prices.
“Asset valuations could correct sharply if, for example, market participants re‐evaluate the prospects for growth, inflation or interest rates,” it said in a statement.
“There are signs of continued loosening in underwriting standards and increased risk-taking in some investment banking businesses.”
However, the report said the UK banking system is sufficiently resilient to potential shocks.
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As the coronavirus pandemic shook the UK economy last year, central banks cut interest rates and undertook asset purchases to support economic activity. The BoE slashed interest rates to record lows of 0.1%.
Since then, risky asset prices have increased, the committee warned, highlighting that asset valuations appear elevated compared to historical norms in a number of markets.
“This partly reflects the improved economic outlook, but may also reflect a ‘search for yield’ and higher risk-taking in a low interest rate environment,” it added.
Market watchers have previously warned that an interest rate rise at the wrong time could tip many borrowers over the edge into more debt and put the breaks on recovery.
Recent soaring gas prices and price inflation due to supply chain issues will have complicated the picture in the future rate path.
The report also highlighted that debt levels for small and medium enterprises (SMEs) have jumped by a quarter during the pandemic, compared to a rise of just 2% for large firms.
“Significantly more SMEs now have debt to service, and while the majority of new debt was relatively cheap due to government loan schemes, this will add to pressure on weaker SMEs,” the FPC warned.
Many of these SMEs had not previously borrowed and some would not have previously met lenders’ lending criteria, leading to increases in the number and scale of more vulnerable businesses.
It said households and businesses were likely to need continued support from the financial system as the economy recovers and government support measures unwind.
Debt vulnerabilities globally have also increased during the pandemic. Across advanced economies, corporate debt-to-GDP ratios have increased in aggregate by 10 percentage points since the end of 2019.
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