The Bank of England has launched the scenario phase of the system-wide exploratory scenario.
This page details the hypothetical market shocks in the system-wide exploratory scenario (SWES). The variable paths can be found within Variable paths in the system-wide exploratory scenario.
The SWES scenario comprises a sudden, sharp shock to global financial markets due to sudden crystallisation of geopolitical tensions. Rates and risky asset prices move sharply, and these moves persist. The shock is amplified by the financial sector, counterparty credit risk becomes elevated, and eventually crystallises. Chart 1 places the peak-to-trough moves in the hypothetical SWES scenario in the context of both recent market events and the most significant 10-day move observed historically for each variable (the axis).
The developments are particularly rapid. For instance, on the first day of the scenario, yields on 10-year nominal gilts increase by around 45 basis points and yields on 10-year index-linked gilts by around 60 basis points. Many of the Day 1 moves in the SWES scenario are roughly in line with, or more severe than, the largest observed historical moves (Chart 2). The aggregate shock in the hypothetical SWES scenario is more severe than observed during the March 2020 ‘dash for cash’ or the September/October 2022 LDI (Liability Driven Investment) episode, as the shocks encapsulated in the SWES scenario are largely faster, wider ranging, and more persistent than in these events.
The SWES hypothetical scenario is not a forecast by the Bank, nor does it represent the Bank’s expectations of the consequences for financial markets of any particular shock. It is also not intended to forecast the consequences of any one shock, including any particular change in global geopolitics. The SWES scenario is a tool to allow the Bank to explore the impact of a hypothetical shock on a range of financial market participants. The scenario has been produced by Bank of England staff, under the guidance of the Financial Policy Committee and the Prudential Regulation Committee.
Chart 1: The global shock in the hypothetical SWES scenario combines elements of the shock observed in the LDI episode and the dash for cash
Comparison of 10-day moves in selected SWES variables against the largest historical observations, and those observed during the dash for cash and LDI episodes (a) (b)
Footnotes
- Sources: Bank of England, Bloomberg Finance L.P, Board of Governors of the Federal Reserve System (US), Refinitiv Eikon from London Stock Exchange Group and Bank calculations.
- (a) The gilt yield, US Treasury yield, corporate bond, and equity back data start from 1 January 2000. The back data for all gilt yields includes September 2022, when yields peaked unusually sharply.
- (b) The increase in yields on US Treasuries is similar to that applied to all non-UK advanced economy government debt of similar maturity. This figure displays yields on 10-year US Treasury yields for indicative purposes.
Day 1
Day 1: A significant geopolitical shock surprises markets, leading to a sharp deterioration in the economic outlook, financial asset prices begin to fall (40% of 10-day shock realised).
A sudden crystallisation of geopolitical tensions causes a sharp deterioration in expectations of economic fundamentals, along with elevated uncertainty about future developments. Media coverage of these events dominates headlines, leading to speculation across social media platforms that the situation is likely to deteriorate further, and that this could have a large impact on financial institutions. Markets begin de-risking, risky asset prices fall, and volatility sharply increases.
There are significant sales of advanced-economy government debt – overwhelming the broader de-risking and ‘flight to safety’ behaviours emerging in markets. Sovereign wealth funds are confirmed to be driving a large volume of these sales; financial market commentary appears nervous at this unusual behaviour by investors typically regarded as stable, long-term holders. Even retail investors, normally considered to be ‘stickier’ than institutional investors, appear more flighty, with personal finance focused social media channels rapidly disseminating news to investors and retail activity on trading platforms picking up.
Changes in asset prices on Day 1 are pronounced, particularly in core fixed-income markets. For instance, yields on 10-year gilts increase by around 45 basis points, and yields on 10-year index-linked gilts by around 60 basis points. These increases are roughly in line with, or in some cases more severe than, the largest one-day changes observed historically (Chart 2). These moves and increases in banks’ funding costs consequently lead to repo rates also rising.
Chart 2: Day 1 moves in some asset prices are roughly in line with, or more severe than the largest one day moves observed historically
Day 1 moves of selected SWES variables compared to the largest historical observations (a)
Footnotes
- Sources: Bank of England, Bloomberg Finance L.P, Board of Governors of the Federal Reserve System (US) and Bank calculations.
- (a) The gilt yield, US Treasury yield, corporate bond, and equity back data start from 1 January 2000. The back data for all gilt yields includes September 2022, when yields peaked unusually sharply.
Volatility also increases in foreign exchange (FX) markets, with suggestions that short covering and technical factors are supporting sterling.
Early economic commentary suggests that open economies with current account deficits, such as the UK, are particularly likely to be affected by this emerging shock.
Day 2
Day 2: Asset prices continue to fall, moves are exacerbated by de-risking at relative value hedge funds and continued unexpected sovereign bond sales by some sovereign wealth funds (55% of 10-day shock realised).
The geopolitical event worsens. Commentators reach views on the jurisdictions that are most likely to be affected by this severe and unexpected shock. These jurisdictions (including the UK) are placed on negative watch by credit rating agencies. Similar views emerge about a group of financial institutions and corporates; these are also placed on negative watch.
Risky asset prices see further sharp declines and continued sales of government bonds drive up yields. Rates implicit in the pricing of associated interest rate derivatives also increase, but to a smaller extent, as the large sales by non-domestic investors are primarily taking place in cash markets rather than derivative markets. This adds to the pressure on hedge funds that are employing relative-value trades, particularly on the basis between bonds and bond futures or other derivatives. Cross-currency bases also widen, reflecting stress in offshore US dollar funding markets.
As a result of the pressure in these areas, wider price volatility, and margin calls, some mid-sized funds that employ relative-value strategies (each with roughly US$10 billion of assets under management, none of which are SWES participants) begin de-risking and taking action to reduce their vulnerability to further price moves. Financing conditions tighten and the cost of repo increases as appetite for counterparty credit risk falls.
Some market commentators speculate that credit rating agencies will need to imminently downgrade the jurisdictions placed on negative watch. This reflects emerging expectations of a severe and persistent deterioration in the global economic outlook, and materially tighter financing conditions for an array of advanced economies as a consequence of the pressure on yields.
Day 3
Day 3: A sovereign wealth fund indicates it will continue selling government bonds and counterparty credit concerns become prominent, with some financial firms taking proactive action (75% of 10-day shock realised).
Market activity remains sporadic, liquidity – including in interbank funding markets – is thin. Asset prices continue to fall. As appetite for counterparty credit risk continues to shrink, the costs of repo financing continue to increase. By the end of Day 3 gilt yields and repo rates have increased significantly (Chart 3).
Chart 3: Gilt yields and repo rates continue to increase on Day 3 of the hypothetical scenario
Evolution of 10-year gilt yields (left) and gilt repo rates (right) over the 10-day horizon encompassed in the price paths, compared to the dash for cash and LDI episodes (a)
One of the sovereign wealth funds that has been selling advanced-economy government debt indicates that they will continue to do so. This further destabilises market confidence, given these institutions’ large holdings of such assets, and prices continue to fall (Chart 4).
Chart 4: 10-year US dollar Treasury yields and sterling investment-grade corporate bond spreads continue to rise over Day 3
Evolution of 10-year US Treasury yields (left) and sterling investment-grade corporate bond spreads (right) over the 10-day horizon encompassed in the price paths, compared to the dash for cash and LDI episodes (a)
As market prices continue to fall, the deteriorating market conditions results in continued forced-selling behaviour from a number of the distressed funds, including distressed trades outside of market hours. Concerns intensify around the creditworthiness of these funds. Rumours circulate that some are asking for additional time to meet their margin payments in full, citing delays and operational issues accessing liquidity. Market participants appear to be reducing exposure to these funds.
Credit rating agencies place more vulnerable corporates on negative watch. The underlying concerns contribute to a further sharp increase in spreads on corporate bonds (Chart 4).
Day 4
Day 4: One of the non-SWES participant mid-sized hedge funds in distress defaults and firms act to sell collateral in the market, driving further asset price falls (85% of 10-day shock realised).
Media coverage of the geopolitical situation continues to dominate headlines and speculation of further deterioration continues unabated. Retail investors continue to be unusually active, and retail fund redemptions remain heightened.
One of the hedge funds in distress – a medium-sized relative value focussed fund – defaults, and their prime brokers act quickly to sell securities collateralising their exposures. Other funds continue to de-risk and there is increased speculation of further defaults. These events markedly increase concerns around counterparty credit risk, and activity in funding markets continues to decrease significantly.
These concerns and de-risking contribute to further price falls in fixed-income markets. Similar moves are observed in risky asset prices, and volatility in equity, FX, and rates markets remain elevated.
The short-covering and technical factors supporting sterling subside. Sterling begins to depreciate against a (trade-weighted) basket of currencies, driven by increasing risk premia on holding UK assets.
Day 5–10 onwards
Day 5–10 onwards: The geopolitical situation remains unstable with no prospect of resolution in the medium term, there are concerns it could evolve into a downturn of similar severity to the 2007/08 global financial crisis (100% of 10-day shock realised).
Tensions remain high and the geopolitical situation remains unstable. There are no signs of tensions abating even in the medium term, and media reporting focusses on expectations that the situation will deteriorate further – although there is no consensus on how or when this may occur.
Expectations of economic fundamentals do not recover and downside risks are significant. Some economic commentators suggest a recession similar in magnitude to the 2007/08 global financial crisis could be imminent which analysts expect would likely require some banks to utilise their capital buffers. The price moves over starting days of the scenario do not retrace, and they, alongside both realised and implied volatility, remain elevated across the rest of the scenario horizon and into the months following (Chart 5).
Chart 5: The price moves in the scenario do not retrace
Evolution of 10-year nominal gilt yields, 10-year index-linked gilt yields, 10-year US Treasury yields, and sterling investment-grade corporate bond spreads
Footnotes
- Sources: Bank of England, Bloomberg Finance L.P, Board of Governors of the Federal Reserve System (US) and Bank calculations.
As markets expected, the sovereigns placed on negative watch on Day 2 – including the UK – are downgraded by a single notch, and due to the heightened uncertainty they remain on negative watch. Markets do not react particularly strongly to the downgrade, as much of its effect had previously been priced in. A small number of financial institutions and corporates are downgraded at the same time. Market participants expect further downgrades to take place in the months following the scenario horizon.
The prime brokers to the defaulted hedge fund quickly reveal their estimates of impact of the default. While it is material for their short-term profitability, it does not call into question their solvency. However media stories continue to question the resilience of funds who may have been particularly exposed to market moves, exacerbating concerns about counterparty credit risk.
Annex
The scenario escalates from an initial crystallisation of geopolitical tensions
Timeline of key events in the hypothetical SWES scenario
