Bank of England Raises Concerns Over Hedge Funds’ Large Bets Against Treasury Bonds

The Bank of England (BoE) has issued a warning regarding the potential risks posed by hedge funds making significant wagers against Treasury securities, emphasizing the potential impact on the global financial system. In its recently published financial stability report, the central bank highlighted a notable increase in short positions in Treasury futures, reaching levels not observed since 2018.

According to the BoE, its “market intelligence” indicates that these futures positions are not outright bets on a decline in government bond prices and subsequent yield increases. Instead, they are trades relative to bonds or swaps, known as “basis trades.” These trades aim to capitalize on minor price disparities between economically similar cash bonds and Treasury futures. However, due to their highly leveraged nature and dependence on low volatility, substantial returns are sought.

The BoE acknowledged that although the market-based finance system experienced turmoil in early 2020 due to the COVID-19 pandemic and the subsequent surge in Treasury volatility and demand for government debt, vulnerabilities still persist. The central bank highlighted the substantial positions built up by leveraged hedge funds in U.S. Treasury futures relative to bonds or swaps. The BoE expressed concern that if these markets were to undergo significant movements, the process of deleveraging these positions could intensify stress in the financial system.

Furthermore, the BoE cautioned that the existing risks and underlying vulnerabilities in the market-based finance system have not been adequately addressed and could resurface swiftly. It particularly emphasized the potential risks to financial stability posed by the abrupt transition to higher interest rates and the current elevated levels of volatility. The ICE BofAML MOVE index, which monitors Treasury price volatility, has recently decreased to around 122 from its peak of 180 in the past 14 years. During this period, the yield on the 10-year U.S. Treasury has fluctuated between approximately 3.30% and just over 4%.