From the Brookings Institution, March 26:
Thinly capitalized hedge funds’ growing role in the enormous and rapidly expanding market for U.S. Treasury securities poses a clear and present danger to financial stability that warrants a new approach from the Federal Reserve during times of extreme market stress, suggests a paper discussed at the Brookings Papers on Economic Activity (BPEA) conference on March 28.
In their paper, “Treasury Market Dysfunction and the Role of the Central Bank,” the authors examine changes in the Treasury market since March 2020, when the Federal Reserve purchased more than $4 trillion of Treasuries and government-backed mortgage securities to calm turmoil in those markets triggered by the COVID pandemic.
“These problems threatened to spill over into other markets as well, potentially interrupting the smooth flow of credit and impairing the implementation of monetary policy,” write the authors, Anil K Kashyap of the University of Chicago, Jeremy C. Stein and Jonathan L. Wallen of Harvard University, and Joshua Younger of Columbia University. “It is natural to wonder whether such episodes of fragility will become more frequent and/or more severe as the Treasury market continues to grow.”
U.S. Treasury debt held by the public reached $28.3 trillion (96% of gross domestic product) by the third quarter of 2024 and continues to climb rapidly, the authors note. They developed a model to examine the incentives and constraints facing three types of institutions in the Treasury market: asset managers such as bond mutual funds, pension funds and insurance companies; broker-dealers; and hedge funds. And they offer recommendations for how the Federal Reserve can best address future episodes of turmoil.
To meet future obligations, asset managers invest directly in Treasury bonds and indirectly through derivatives such as futures and swaps. Both their direct holdings and derivative positions are “long,” meaning they are exposed to losses if interest rates rise and the value of their holdings and positions falls.
Broker-dealers and, increasingly, hedge funds in essence lend their balance sheets to the asset managers. They directly hold the Treasury securities that the asset managers prefer to hold synthetically through derivatives. The hedge funds and broker-dealers hedge their direct holdings by taking a “short” position in derivatives (the opposite of the asset managers). If interest rates rise and the value of their direct holdings declines, then the value of their derivatives positions increases to offset the direct holdings’ decline. The dealers and hedge funds are compensated for this service through the spread, known as a “cash-futures basis,” between the returns on Treasuries and Treasury derivatives.
The vulnerability arises because the hedge funds, which are more lightly regulated than broker-dealers, finance their Treasury holdings almost entirely by borrowing against them. Thus, any number of shocks can lead the hedge funds to quickly exit the trade, requiring the broker-dealers to step in, at least in the short term....
