ROI-Hedge funds pose greater threat to US Treasuries than China ever did: McGeever

For years, the biggest threat to the U.S. government bond ​market was supposedly China. Many feared a politically motivated fire sale by America’s adversary could destabilize the U.S. financial ​system. That never happened. But as Beijing has shed its Treasury exposure, a new – and ‌arguably ​greater – bond market risk has arisen closer to home: domestic "fast money." Over the past several years, China and other central banks have gradually shrunk their footprint in the $29 trillion U.S. Treasury market, while private-sector buyers, including hedge funds and speculators, have expanded theirs. This has arguably reduced stability in the world's largest and most liquid financial market.

In 2011, China's official holdings of Treasuries stood ‌at $1.3 trillion. That was 14% of all outstanding Treasuries. The big fear then was that Washington's rising economic and geopolitical rival could weaponize its financial clout by dumping these bonds, sending U.S. borrowing costs through the roof, tanking the dollar, and potentially plunging the U.S. economy into recession. The chances of that doomsday scenario unfolding were always slim. It wasn’t really in Beijing's interests to torpedo its huge foreign exchange reserves and biggest export market. The nightmare scenario for the U.S. would also have been a financial and economic disaster for ‌China. The likelihood of "mutually assured destruction" meant the trigger was never pulled.

Instead, China's huge footprint, and that of other central banks, was a source of stability. Let’s call it "mutually assured security." That security has now largely vanished.

CHINA'S OFFICIAL FOOTPRINT MELTS Large central ‌banks have long been paring back their exposure to Treasuries.

Beijing's "official" Treasury holdings are now just $633 billion, barely 2% of all publicly held Treasuries. China is widely assumed to hold more through state banks and offshore entities. Foreign central banks, which held 40% of the U.S. government bond market in 2008, now have only a 12% share. As these conservative, long-term, price-insensitive investors have moved aside, the marginal buyers of U.S. Treasuries have become hedge funds – yield-sensitive, nimble private-sector investors with shorter time horizons and often quite a bit of leverage. Hedge funds now own some $2.6 trillion of all Treasuries outstanding, more than 8% of the market.

This makes for ⁠a "less-stable equilibrium," according ​to UniCredit, leaving the world's most important financial market more vulnerable to ⁠bouts of volatility because small moves in bond yields could trigger margin calls and forced deleveraging. But when you consider these funds also have a large "short" exposure, their footprint is even bigger. Hedge funds’ gross U.S. Treasury exposures late last year reached $4.0 trillion, including $1.6 trillion in short exposure, according to a Fed paper ⁠published in June. To finance these positions and source collateral, hedge funds' repo cash borrowing ballooned to $3.0 trillion.

Crucially, hedge funds' gross Treasury exposures, repo borrowing, and monthly turnover in Treasury markets have all more than doubled since the beginning of 2023. This activity is incredibly concentrated too. The 50 ​largest funds account for approximately 90% of the total. "The scale of this expansion is striking," noted Federal Reserve economist and author of the paper, Philip J. Monin, adding: "The combination of large scale, high concentration, and elevated leverage creates the ⁠potential for systemic stress if multiple strategies face simultaneous pressure or if severe shocks affect the largest participants."

STRIKING, OR ALARMING? There has been no blow-up, of course – not yet, anyway. Fears about a collapse of the "basis trade" – hedge funds' strategy of using large amounts of leverage to take advantage of small differences between Treasury futures and ⁠cash ​bond prices – are so far unfounded. Investors, regulators and policymakers are also well aware of all these risks.

Analysts at Capital Economics are among those who reckon regulators' concerns about hedge funds' growing presence in the Treasury market are probably overblown. Funds have reduced their short positions in futures contracts quite substantially this year, and the move has so far been orderly. Still, no matter how you look at it, hedge funds are more flighty and highly leveraged than reserve managers.

Central banks are likely to ⁠buy more Treasuries and dollars when they fall in value to maintain their foreign-exchange reserve balances. Private investors, on the other hand, are more likely to cut their losses and sell, intensifying the negative feedback loop. Right now, as Treasuries and global sovereign ⁠bonds undergo their heaviest selloff in decades, it is worth asking ⁠whether changes in the ownership structure of the U.S. bond market increase the chance that an "accident" turns a correction into a crisis. Where is the People's Bank of China when you need it?

(The opinions expressed here are those of the author, a columnist for Reuters) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on LinkedIn, ‌and X.

And listen to the Morning Bid ‌daily podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets and finance seven ​days a week. (By Jamie McGeever, Editing by Marguerita Choy)