Bank of England official warns hedge funds increase bond market spillover risk

Bank of England Deputy Governor Sarah Breeden has warned that the expanding role of hedge funds in global government bond markets increases the risk of financial shocks spreading across different markets. Speaking at the IMF-World Bank annual meetings in Bangkok, Breeden noted a structural shift where core sovereign markets are increasingly dominated by price-sensitive, leveraged, and international hedge funds rather than traditional insurers and pension funds.

While acknowledging that hedge funds can support market liquidity and efficiency, Breeden highlighted that high leverage, crowded trading strategies, and investor redemptions could trigger synchronized deleveraging. Such movements can amplify market stress and spill over into prime brokerage businesses at major banks.

A key concern is the “basis trade,” where funds use substantial leverage to exploit small price gaps between cash government bonds and matching futures. This risk follows recent volatility in sovereign debt, including significant yield increases in U.S. Treasuries, U.K. gilts, and French government bonds.