GILTS: Bear Flattening As Oil Firms

The financial system has so far remained resilient since the outbreak of the conflict in the Middle East, the Bank of England's Financial Stability Committee said following its March meeting, but the supply shock could exacerbate preexisting vulnerabilities in the financial system.

• The resilience means that UK banking system still has the capacity to "support households and businesses even if economic and financial conditions were to be substantially worse than expected," according to the FPC's March 27 meeting said, even as financial conditions are seen tightening and uncertainty is elevated.
• Market participants should incorporate "scenarios involving further sudden and significant price adjustments into their stress testing and liquidity preparedness," as elevated uncertainty increases "the likelihood and magnitude of sharp market shifts in response to new information," it said.
• The shock "is likely to interact with vulnerabilities previously identified by the FPC in sovereign debt markets, risky asset valuations and risky credit markets, notably private credit," it said, adding that multiple such vulnerabilities "could crystallise at the same time."
• Sovereign bond markets have "absorbed high volatility and volumes so far underpinned by functioning repo markets," it said.
• However, the high levels of leverage and similarity of strategies employed by a small number of hedge funds in these markets risk "a disorderly unwind of positions, causing a jump to illiquidity in core markets," against a backdrop of "historically high" issuance.
• The FPC decided to maintain the countercyclical buffer (CCyB) at 2%.

Hedge fund deleveraging raises the risk of illiquidity in core UK markets, although there has not yet been liquidity shortages following the outbreak of conflict in the Middle East, the Bank of England Financial Policy Committee said following its March meeting.

• Investment firms, largely hedge funds, have made very large adjustments to positions in the wake of the Iran shock and have lowered their net gilt exposure substantially, the FPC said.
• Hedge funds with the highest degree of leverage in the gilt market also had large repo positions in other bond markets, such as U.S. treasury bonds.
• These cross-market positions and the use of similar trading strategies "increased the risk of disorderly unwinds causing jumps to illiquidity in core UK markets," the FPC said.
• The BOE said that hedge funds have lowered their aggregate net gilt repo borrowing by 21% (GBP19 billion) compared to pre-conflict levels although borrowing levels remained high, at GBP74 billion.
• Although the BOE said markets had proven resilient so far price moves had been amplified by hedge fund deleveraging, particularly at the short-end of the curve.
• The FPC noted that in the currently highly volatile environment it was "harder for markets to price underlying economic fundamentals" and this increased "the likelihood and magnitude of sharp market shifts."