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The Bank of England has warned of rising “vulnerabilities” in the financial system stemming from increased bets by hedge funds against US government bonds, which reached a record high of $1tn in recent months.
The BoE said on Wednesday that if hedge funds unwound these “short” positions it would have “the potential to amplify the transmission of a future stress”. These short bets are often part of so-called basis trades, where hedge funds aim to profit from small discrepancies between prices of US Treasuries and futures contracts linked to them.
A period of volatility in global financial markets in August “illustrates the potential vulnerabilities in market-based finance to amplify shocks”, the BoE said in a report on the September meeting of its financial policy committee.
“While there was evidence that investor deleveraging had amplified price moves, it did not spill over or materially affect the functioning of core markets,” it said.
However, the central bank warned: “It might have done so if subsequent economic news had not been positive or deleveraging had been more significant or broad based.” It added that valuations remained “stretched”, leaving markets “susceptible to a sharp correction”.
There is potential for volatility in US Treasury markets — which act as a benchmark for funding costs worldwide — after the Federal Reserve started to cut interest rates aggressively last month and as the country prepares for a closely fought presidential election.
The BoE said its survey of 55 financial market participants over the summer found they believed geopolitical turmoil and cyber attacks were the biggest risks to UK financial stability. More than 90 per cent identified geopolitical events as a risk, while 80 per cent cited cyber risks.
Officials are closely monitoring the impact of the conflict in the Middle East on financial markets, including energy markets.
The BoE said “the current period of elevated geopolitical risk and uncertainty . . . could place further pressure on sovereign debt levels and borrowing costs”. It added that high public debt levels in major economies could have consequences for UK financial stability.
The net short positioning of hedge funds in US Treasury futures markets hit a new high of $1tn in recent months, up from a previous peak of $875bn. “Relative to the size of the US treasury market, this was larger than the previous high reached in 2019,” the BoE said.
A rapid deleveraging of these short positions could be triggered by a number of factors, including “if repo market functioning were to deteriorate materially; if counterparty credit risk were to increase; or if investors in the basis trade were to take losses on their positions”.
The BoE said the UK economic environment had improved and credit conditions had eased after it started to cut interest rates in August. But it warned that “pockets of vulnerability among highly leveraged corporates” remained, including at private equity-owned companies.
Lower interest rates had eased the pressure on UK households, the BoE said, particularly the fifth of mortgage holders on floating rates. This will also reduce the extra cost for the 1.4mn households that will need to refinance fixed-rate mortgages in the next year from over £200 per month last year to £150 per month.
BoE officials also discussed how increased use of artificial intelligence and machine learning could affect financial stability. Warning that AI-based trading algorithms could lead to “increasingly correlated trading strategies”, it announced plans to publish an assessment of the main risks from AI and how it will monitor them in the first half of next year.
