Tension in the UK and EU credit markets is reaching crisis levels

At mid-day, the Bank of England had no other choice but to step in in an effort to restore market confidence. The Bank indicated they will carry out temporary purchases of long-dated UK government bonds from today in order to "restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses". It is too early to say whether this will be successful or not.

What is the problem ?
On 23 September, the UK government unveiled a new fiscal package which will increase the level of public debt and might complicate the Bank’s task to lower inflation. This resulted in a drop of confidence in the country. This is a problem for any country facing such a situation. But this is worse for the UK. The country is more reliant than ever on inflows of foreign money to finance its excess consumption. The current account deficit was at a record high of 8.3 % of GDP in the first quarter this year. Even in the best case scenario, if it falls to 4 %, this will be complicated to finance. As foreign investors head for the exit worried about the government’s ballooning pile of debt, there is a material risk that the UK might not be able to attract enough foreign capital to fund its debt at current levels of interest. In the worst case scenario, the UK might need to be forced to sell assets to foreigners. But we are not in this situation yet.

What are the consequences ?
The UK is becoming a major credit risk not only for GBP assets but also for the rest of the world, primarily the eurozone. We see some kind of contagion effect in the eurozone credit market.

The spread between the 10-year Italian government bond and the 10-year German government bond which serves as a benchmark is above 250 basis points again – see chart 2. It is now back to pre-Covid levels when ECB President Christine Lagarde put her foot in her mouth by saying that "the European Central Bank is not here to close spreads". The widening in spreads not only reflects concerns about Giorgia Meloni’s victory in Italy but contagion from the UK credit risk too.

We also closely monitor broader measures of financial stress, such as the ECB Systemic Risk Indicator – see chart 3. It is above 0.40 – which is usually considered as the risk-zone. If it continues increasing, it could reach in a matter of weeks levels of 2011 – at the peak of the European sovereign debt crisis. Here again several factors play a role (the European energy crisis, the risk of a eurozone recession etc.). But contagion from the UK is noticeable as well.

We are now in a situation where the markets could easily break. We cannot exclude that other central banks will step in, following the examples of the Bank of England, if financial conditions continue to deteriorate. This is the right moment to be careful if you are exposed to the market.