Markets face 'sharp correction' if mood sours on AI or Fed freedom, Bank of England says

The Bank of England has issued a sharp warning about increased risks of a "sharp market correction" in global financial markets, citing two primary concerns: a potential downturn in investor sentiment regarding artificial intelligence prospects and a weakening of the U.S. Federal Reserve's independence. The BoE noted that U.S. stock valuations, particularly the S&P 500's concentration in a few AI-focused tech giants, are reminiscent of dotcom bubble peaks, making markets vulnerable to shifting AI expectations. Additionally, it cautioned that a perceived loss of Fed credibility could lead to significant repricing of U.S. dollar assets and sovereign debt, triggering global spillovers and increased volatility, which would also impact British government borrowing costs.

Analysis

LONDON, Oct 8 (Reuters) - Global financial markets could tumble if investors' mood sours on the prospects for artificial intelligence or the independence of the U.S. Federal Reserve, the Bank of England warned on Wednesday. The BoE said share price valuations on U.S. stock markets were similar to those seen near the peak of the dotcom bubble on some measures and noted that U.S. government bonds were vulnerable to any weakening in the Fed's credibility. Sign up here. "The risk of a sharp market correction has increased," the BoE's Financial Policy Committee said in a quarterly update, in its sharpest warning to date of the dangers of an AI-triggered market slump, adding that the risk of spillovers to Britain's financial system from such a shock was "material". The FPC is chaired by BoE Governor Andrew Bailey and focuses on financial stability risks. Bailey told Britain's parliament last month that he was "very concerned" about threats to Fed independence. LOSS OF FED INDEPENDENCE WOULD CAUSE GLOBAL SHOCK President Donald Trump has repeatedly urged the U.S. central bank to slash interest rates and has sought to fire one of its policymakers, Lisa Cook. "A sudden or significant change in perceptions of Federal Reserve credibility could result in a sharp repricing of U.S. dollar assets, including in U.S. sovereign debt markets, with the potential for increased volatility, risk premia and global spillovers," the BoE said. British government borrowing costs are closely correlated with U.S. Treasury yields, and a fall in U.S. bond prices would probably push up the cost of servicing new British public debt. Thirty-year gilt yields hit their highest since 1998 last month and yields for shorter maturities - where most British borrowing is concentrated - have risen too. The BoE said this increase reflected concerns about the difficulty of reining in high borrowing across advanced economies, amplified by political uncertainty in France and Japan. AI VALUATIONS ECHO PEAK OF DOTCOM BOOM On AI, the BoE said that 30% of the U.S. S&P 500's valuation (.SPX) was made up by the five largest companies, the greatest concentration in 50 years. Chipmaker Nvidia (NVDA.O), Microsoft (MSFT.O), Apple (AAPL.O), Google-parent Alphabet , Amazon (AMZN.O) and Facebook-parent Meta (META.O) have all bet heavily on AI. Share valuations based on past earnings were the most stretched since the dotcom bubble 25 years ago, though looked less so based on investors' expectations for future profits. "This, when combined with increasing concentration within market indices, leaves markets particularly exposed should expectations around the impact of AI become less optimistic," the BoE said. Last month Meta boss Mark Zuckerberg said he would rather misspend a couple of hundred billion dollars than risk being late to the AI expansion. In August, almost half of fund managers polled by Bank of America judged that owning the seven largest U.S. tech stocks was the most crowded trade in the industry. Despite these concerns, the S&P 500 hit a record high on Tuesday, up 14% on the year to date. UK DOMESTIC RISKS LITTLE CHANGED The central bank saw little change in domestic financial stability risks, as households and businesses continued to cope with rising inflation - which it forecasts hit 4% in September - and with increased borrowing costs compared with past years. Risk managers surveyed by the BoE were more confident in the stability of the British financial system than six months ago, and viewed the main dangers as coming from cyberattacks and geopolitical factors. The BoE left unchanged its main tools for regulating banks. It kept the countercyclical capital buffer (CCyB) steady at 2% and after an annual review left the minimum leverage ratio at 3.25%. Writing by David Milliken Editing by Gareth Jones Our Standards: The Thomson Reuters Trust Principles. The Bank of England (BoE) has issued a "sharp warning" regarding an increased risk of a "sharp market correction" in global financial markets, citing two primary catalysts: investor sentiment around artificial intelligence (AI) prospects and the independence of the U.S. Federal Reserve. The BoE's Financial Policy Committee noted potential "material" spillovers to Britain's financial system, indicating a strongly negative sentiment and high market impact. U.S. stock market valuations, particularly the S&P 500's concentration, bear resemblance to dotcom bubble peaks; the top five companies now constitute 30% of the index's valuation, marking the highest concentration in 50 years. This leaves markets "particularly exposed" should AI expectations wane, a concern amplified by Bank of America's poll indicating almost half of fund managers view the seven largest U.S. tech stocks as a "crowded trade." Furthermore, the BoE cautioned that a "sudden or significant change in perceptions of Federal Reserve credibility" could instigate a sharp repricing of U.S. dollar assets, including sovereign debt, and elevate global volatility. This directly impacts the UK, as British government borrowing costs closely correlate with U.S. Treasury yields, with 30-year gilt yields having recently hit their highest level since 1998. While the BoE noted little change in domestic UK financial stability risks, the confluence of stretched equity valuations fueled by AI hype and systemic risk from potential challenges to Fed independence presents a precarious global market outlook. The overall tone from the BoE is distinctly cautious, underscoring elevated financial instability concerns.

Key Decisions for Investors

• Investors should critically evaluate their portfolio's concentration in AI-dependent large-cap technology stocks, considering the BoE's comparison to dotcom-era valuations and widespread "crowded trade" sentiment.
• Closely monitor political developments impacting U.S. Federal Reserve independence, as any perceived loss of credibility could trigger sharp repricing across U.S. dollar assets and sovereign debt, leading to significant global volatility.
• Assess and stress-test fixed income portfolios, particularly U.S. Treasury and UK gilt exposures, given the potential for increased volatility and the recent surge in 30-year gilt yields to 1998 highs.
• Consider implementing hedging strategies or defensive rebalancing to mitigate potential downside risk stemming from the identified AI valuation concerns and systemic monetary policy uncertainties.