The Bank of England (BoE) has issued a warning about the potential risks posed by hedge funds’ large bets against Treasury securities. In its latest financial stability report, published on Wednesday, the UK central bank highlighted the significant increase in short positions in Treasury futures. These positions have reached levels not seen since 2018.
According to the BoE, its market intelligence suggests that these futures positions are not simply bets on a fall in government bond prices and a rise in yields. Instead, they are trades relative to bonds or swaps. Known as “basis trades,” these transactions aim to exploit small price differences between economically similar cash bonds and Treasury futures. To achieve significant returns, these trades rely on high leverage and are reliant on low volatility.
The bond market experienced a major upheaval in early 2020 during the COVID pandemic when Treasury volatility surged alongside a sharp increase in demand for government debt.
Despite recent improvements, vulnerabilities still exist within the system of market-based finance, warns the BoE. It highlights that leveraged hedge funds have been accumulating substantial positions in US Treasury futures over recent months, which market intelligence indicates are relative to bonds or swaps. If these markets were to experience significant movements, the process of deleveraging these positions could intensify stress in the financial system.
The BoE has also identified other underlying vulnerabilities in the system of market-based finance that have yet to be fully addressed. It cautions that these vulnerabilities could resurface rapidly, especially considering the abrupt shift to higher interest rates and the current high volatility, both of which increase the likelihood of crystallizing market-based finance vulnerabilities and posing risks to financial stability.
Presently, the ICE BofAML MOVE index, which monitors Treasury price volatility, is trading at around 122. This is considerably lower than the 14-year peak of around 180 observed at the beginning of this year. During this period, the yield on the 10-year US Treasury has fluctuated within a range of approximately 3.30% to just above 4%.
Overall, the BoE’s report serves as a reminder of the potential dangers associated with hedge funds’ large bets against Treasury securities. The risks posed by these bets, along with other vulnerabilities within market-based finance, could have serious consequences for global financial stability. It is crucial for market participants and regulators to remain vigilant and address these issues promptly.