The build-up of US debt and hedge-fund bets against US Treasuries have prompted warnings that a sharp sell-off in US government bonds could cause hedge funds to dump their holdings, setting off a doom loop that sends financial markets into a tailspin.
Hedge-fund bets against US Treasuries threaten the global financial system
Could hedge-fund bets against US Treasuries pose a threat to the global financial system? The Bank of England certainly thinks so, having issued just such a warning in October 2024, after hedge-fund bets against US government bonds reached a record high of $1 trillion at the end of September. The rise in these basis trades, where hedge funds aim to profit from small discrepancies between the prices of US Treasuries and futures contracts linked to them, followed a surge in US government borrowing costs, with the yield on 10-year Treasuries climbing by 63 basis points to 4.36% over the month of September.1
The Bank of England’s warning remains pertinent given the scale of US debt, which, along with interest costs, raises questions about the long-term health of the US economy. The Telegraph newspaper asked whether “bond vigilantes [could] punish Washington and impose fiscal discipline, just as they did in Britain in the aftermath of Liz Truss’s mini-Budget”.
Bank of England officials appear to think so, warning that – in a worst-case scenario – the trades could trigger a market meltdown. The danger arises from the fact that hedge funds are taking these positions using money from the repo market, a form of short-term borrowing from big banks with government bonds used as collateral to buy more debt. That leaves the hedge funds with hyper-leveraged positions: at the end of 2023, hedge funds were exposed to over $550 billion in Treasury trades, backed by just $10 billion of their own cash, according to the Federal Reserve.2
The Bank of England argues that various developments could cause hedge funds to sell their Treasury holdings, precipitating market stress. They include hedge-fund losses on other investments that prompt them to dump Treasuries to raise cash.
The European Central Bank (ECB) is also worried about the potential implications for global financial stability of a sharp and sudden sell-off in US Treasuries, the risk-free asset off which every other financial instrument is priced. It warned in May 2024 that “the build-up of hedge funds’ leveraged exposures in the US Treasury market has given rise to financial stability concerns”. It added that “disruptions in the repo market could still force some entities to unwind their basis trades, fuelling dislocations in the US Treasury market”.
The ECB is concerned that a US Treasury crash could have significant repercussions for the eurozone given “the high correlation between US Treasuries and euro area government bonds, and when the same counterparties are active in both markets”, adding that “sufficient liquidity in the spot, futures and repo markets in the United States is therefore crucial to contain vulnerabilities globally”. The ECB says that a build-up of hedge-fund exposure has also been observed in the euro-area government-bond market, but the size of basis-trade activity seems contained.3
All this raises the question of whether the US debt build-up is sustainable and how likely a Treasury sell-off is. US government debt has certainly surged over the past 20 years or so, partially reflecting the impact on government finances of events such as the global financial crisis of 2007-08 and the Covid-19 pandemic. Major financial institutions do not appear concerned. JP Morgan, for example, says that US monetary policymakers have maintained credibility, investor demand for US Treasury assets is still strong, and the tax base is robust.4
Moreover, RBC Wealth Management argues that US debt has always been a divisive matter, and that “not only is there disagreement on its causes and fixes, but no one can seem to agree if, or when, the federal debt becomes a concern”. Its view is that the federal debt “is a manageable concern and that the US is nowhere near a default risk”.5
Pictet Asset Management is less sanguine about the outlook for US debt. It warns that US debt dynamics are on a dangerous path that could quickly challenge its sustainability going forward. Pictet argues that a tipping point could occur in the next five years, when debt servicing outlays will rise to over 60% of the deficit.
However, Pictet concludes that the complete demise of the US dollar as a global reserve currency is unlikely in the immediate future, barring any catastrophic extreme development. It believes a more likely outcome is the eventual transition to a multipolar arrangement whereby the US dollar maintains a role as a reference currency, but instead of accounting for 46% of global reserves and 90% of global transactions, those percentages fall somewhere closer to 30% of reserves and 40–50% of global transactions.
That, Pictet believes, would be a preferable arrangement, both for the US and the rest of the world, because “the current equilibrium has led to exacerbated global imbalances with several undesirable consequences, including underinvestment in surplus-generating countries, increased income inequality, economic fragilities and US fiscal excesses”.
Sources
1 https://www.telegraph.co.uk/business/2024/11/05/1-trillion-us-debt-bet-hanging-over-trump-harris-election/
2 https://www.telegraph.co.uk/business/2024/11/05/1-trillion-us-debt-bet-hanging-over-trump-harris-election/
3 https://www.ecb.europa.eu/press/financial-stability-publications/fsr/focus/2024/html/ecb.fsrbox202405_03~09cad3d18d.en.html
4 https://www.chase.com/personal/investments/learning-and-insights/article/tmt-june-twenty-eight-twenty-four
5 https://www.rbcwealthmanagement.com/en-us/insights/us-debt-dilemma-no-quick-fixes-and-no-catastrophes
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