Market News

(Bloomberg) -- The Bank of England warned that elevated hedge fund leverage in gilts, alongside exposure to artificial intelligence assets and corporate debt, raise the risk of stress spilling across markets.

That leaves markets more vulnerable to strains that "crystallise at the same time," the BOE noted in its quarterly financial stability record. That warning comes with the UK 10-year government bond yield already near levels last seen during the 2008 financial crisis.

The BOE pointed to the financial policy committee's ongoing consideration of measures to improve gilt repo market resilience and manage "risks both from the increase in market leverage already seen over the past 18 months," which will likely be released in early 2027.

"Although hedge fund leverage in the gilt market has been stable, it remains elevated, and deeper interconnections between vulnerabilities means the risk of a sharp adjustment persists," the BOE policymakers wrote. "This underlines the importance of the Bank's work on gilt repo market resilience."

The BOE has previously cited risks from elevated hedge fund leverage in the gilt market, but given funds' exposure to both tech assets and sovereign bonds, cross-asset spillovers from already strained debt markets could create further tension.

Sterling repurchase, or repo, markets — where institutions borrow cash against gilts to finance leveraged trades — have grown in recent years, leaving more investors reliant on gilt markets for funding. That has increased the potential for stress to spread if they are forced to unwind positions.

The BOE cited Sterling Money Market Daily data showing that since 2023, gilt repo dealers' net cash lending to non-bank financial institutions has doubled to £200 billion ($266 billion).

Gilt yields have jumped alongside global government bond markets, as elevated energy prices stemming from the Middle East conflict fuel concerns that inflation will remain higher for longer and force central banks to tighten policy further.

"The re-escalation of the conflict and the associated rises in oil, gas and refined product prices are leading to a more protracted negative energy supply shock to the global economy," the BOE wrote.

Higher energy prices are adding to pressure as European gas storage levels come under strain. Combined with heavy public borrowing, rising debt-servicing costs and increased AI debt issuance, that is putting upward pressure on yields and testing the gilt market's ability to absorb shocks without sharp price moves.

"Persistently higher sovereign yields could contribute to tighter financing conditions for households and businesses, increase market volatility and constrain advanced economies' capacity to respond to future shocks," the BOE said.