Bank of England flags AI correction risk for gilt markets

The Bank of England warned that stretched AI valuations could face a sharper correction, with consequences for growth and sovereign bond yields.

July selloff stays contained

The central bank’s Financial Policy Committee said in its quarterly financial stability record that vulnerabilities across markets are becoming more connected. Policymakers said the chance of several risks hitting at the same time had increased since the previous review.

AI-linked assets were one focus, alongside risky credit, sovereign debt and a possible re-escalation of conflict in the Middle East. The bank said a longer supply shock from the region could add pressure to the world economy and, in turn, to government bond markets.

The committee said the July bout of selling in AI shares was intensified by investors cutting back stretched positions and reducing leverage. It also said that episode did not spread into core markets, leaving the main concern on what could happen if a later correction proved deeper.

The BOE tied the risk to expectations that AI will lift productivity. If investors mark down those expectations, the bank said the repricing could move beyond AI stocks and affect sovereign debt markets, where higher yields can tighten credit for households and companies.

Bailey favors testing first

Andrew Bailey, governor of the Bank of England, wrote Wednesday that AI has direct implications for financial stability, including cyber risk. He said firms and regulators should test AI systems carefully before relying on formal rules as the first line of defense.

“Understanding, testing and establishing credible points of intervention must come first,” Bailey wrote. He also said a more formal regulatory framework may emerge over time, but argued that supervision should begin with knowledge of how the technology works in practice.

In the BOE’s twice-yearly systemic risk survey, published the same day, AI was cited by a record number of participants, according to the bank. The committee also said risky credit markets, including parts of private credit, remain exposed if financing conditions tighten.

The bank kept a separate policy track open on bank leverage. It said further analysis supported July proposals to loosen an absolute leverage cap on banks, while planned gilt market reforms, due for consultation in early 2027, may be better suited to managing leverage in government bond trading.

The committee left itself a backstop. If risks shift, it said it could raise banks’ leverage ratio buffers by 25 basis points, equal to 0.25 percentage point, while continuing to review leverage in the gilt market.

Three market paths emerge

If AI earnings and productivity assumptions hold, the global macro effect would be steadier growth expectations and less pressure on sovereign yields from technology repricing. For the Bank of England, that path would keep the focus on testing, cyber controls and targeted market surveillance; for banks and asset managers, it would reduce the chance of forced selling tied to AI exposures.

If AI valuations instead correct more deeply than in July, the mechanism would run through lower risk appetite, reduced collateral values and tighter financing for leveraged investors. That would test the BOE’s financial stability tools, hurt companies most dependent on AI capital spending and leave credit funds facing more expensive refinancing.

If Middle East risks re-escalate, the BOE’s stated concern is a longer supply shock feeding into energy costs, inflation expectations and sovereign yields. The main open question is whether AI repricing, private credit stress and gilt-market leverage stay separate, or whether one shock forces investors to cut risk across several markets at once.