The Bank of England (BoE) has issued a cautionary note about the growing vulnerabilities in the financial system due to hedge funds’ record-setting short positions against US government bonds, according to a report by the Financial Times.
These positions, which have ballooned to a historic high of $1tn, could potentially destabilise markets if unwound quickly, the BoE stated on Wednesday.
The central bank’s warning comes as part of a report summarising discussions from its September financial policy committee meeting, highlighting concerns that these large-scale short bets, primarily part of “basis trades” strategies, could amplify future market stress. Basis trades are commonly employed by hedge funds to profit from price discrepancies between US Treasury bonds and their associated futures contracts.
“If these short positions were rapidly closed, it could significantly amplify the impact of future financial stress,” the BoE noted. “Recent volatility in global markets underscores the potential for market-based finance to exacerbate shocks.”
The BoE pointed to a period of heightened market turbulence in August as a case study of how leveraged positions can intensify price swings. While there was no immediate spillover into core financial markets, the central bank cautioned that the situation might have been different had economic news been less favourable or if deleveraging had been more severe.
It added that the continued “stretched” asset valuations left markets “susceptible to a sharp correction.”
The Bank of England warned that several factors could trigger a rapid unwinding of hedge fund positions in the US Treasury market, which serves as a global benchmark for funding costs. These include disruptions in the repo market, a sudden increase in counterparty credit risk, or substantial losses incurred by investors engaged in basis trades.
This concern is heightened by the Federal Reserve’s recent aggressive interest rate cuts and uncertainty surrounding the upcoming US presidential election, which could both contribute to further volatility in US Treasury markets.
