RPT-ROI-Bond termites, not vigilantes, are the big risk: Mike Dolan

By Mike Dolan

LONDON, Dec 3 (Reuters) - Worry less about so-called vigilantes and pay more attention to bond-market termites.

That, at least, is the message from financial watchdogs wary that the sheer scale and growth of today's sovereign bond markets is drawing in ever larger hedge fund activity — not mainly to take directional views or enforce fiscal discipline, but to corner niches of these vast markets with cheap leverage and arbitrage trades.

There is a positive side: these players add liquidity that helps fund burgeoning public debt piles. But many regulators fear the size of the leveraged bets is making these markets more fragile beneath the surface, leaving them more prone to seismic blowouts in the event of any future shock.

This deflects the focus away from the now‑tired image of high‑principled "bond market vigilantes" punishing wayward governments for fiscal missteps and ever larger debts with capital strikes or short selling.

That goes on too and has a significant impact on borrowing costs over time. Yet Treasuries and government debt managers have become quite adept at stymieing that short term with deft management of schedules and maturities. In the last resort, central banks have shown for well over a decade that they have the tools to directly intervene too.

Structural fragility is a different order of threat. It is arguably more worrying as accidents rather than intentions cause the damage, and the broader financial system could potentially be infected by mistake.

Tighter controls may well be warranted, but that could be a forlorn case in a world where deregulation appears back in vogue.

The growth in hedge fund activity in sovereign debt is not new and has been rising for at least three years — along with the considerable hand‑wringing about it.

Leveraged relative‑value trades, such as the cash‑futures "basis trade" that has quadrupled to well over $1 trillion in U.S. Treasuries over three years and is still growing, exploit small price differences between bonds and their futures contracts.

Central banks reckon this activity is now evident and growing in all major government bond markets, with hedge fund use of securities repurchase market, or repo, a key focus.

For many observers, this is a left‑field global risk, distinct from the usual concerns about fiscal or monetary policy.

VULNERABILITIES

Only last week, the new head of the Bank for International Settlements, Pablo Hernandez de Cos, warned that reining in hedge funds' ability to make highly leveraged bets in government bond markets should be a priority as public debt climbs.

"The growing intermediation of record-high public debt levels by NBFIs (non-bank financial institutions) introduces significant new financial stability challenges," de Cos said.

"This greater presence also increases the likelihood of sharp non-linear sovereign yield spikes through a number of channels," he said, adding rising use of currency swaps and repos in tandem amplified the spillovers from any shocks.

De Cos homed in on repo trades to show the scale of what's happening and how it could be addressed.

About 70% of bilateral repos taken out by hedge funds in dollars and 50% in euros are offered at zero "haircut," or at no discount on the collateral posted, the BIS chief said. Applying minimum haircuts would be one way to limit the scale of the trades, he added.

How that would be applied or enforced is less clear - especially when the U.S. is pushing for lighter regulation.

The Bank of England on Tuesday echoed the BIS's concerns in its own backyard. It said hedge fund borrowing against British government bonds, or gilts, reached close to 100 billion pounds last month, tied in part to the cash-futures basis trade.

The BoE added that a small number of hedge funds account for more than 90% of net gilt repo borrowing, often at zero or near-zero collateral haircuts - and at very short maturities requiring regular refinancing.

"These vulnerabilities, in the context of compressed risk premia in a highly uncertain global environment, increase the risk of sharp moves," the BoE said in its Financial Stability Report, adding those shocks could simply include "correlation shifts outside historical norms."

OVERHEATING

The counter view is that these trades have been elevated for a long time and have ebbed and flowed at times without major disruption even if rising overall along with expanding debt loads.

But shocks, by definition, are hard to insulate against.

Strategists at Societe Generale flag another risk: that the U.S. Federal Reserve ends up fuelling market overheating, now that it has stopped its balance‑sheet rundown at historically high bank‑reserve levels and has resumed cutting interest rates. With hedge fund leverage expanding via repo and prime brokers at banks, the Fed is now wary of draining liquidity for fear of blowing up the gigantic "basis trade" in the bond market.

Unmanageable excess could well be 2026's undoing.

The opinions expressed here are those of the author, a columnist for Reuters

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