China’s retreat did not trigger the feared bond shock. A more subtle danger is building as leveraged funds take a larger role.
For years, China was considered the main threat to the US Treasury market. Investors feared that Beijing might, for political reasons, sell off its Treasury holdings on a massive scale, driving up borrowing costs, weakening the dollar, and triggering turmoil in the financial system. But that never happened. Instead, the decline in China’s presence has exposed another risk – one that has emerged within the US market itself: the activity of so-called “fast money,” particularly hedge funds.
According to Reuters
In recent years, China and other central banks have gradually reduced their share of the roughly $29 trillion US Treasury market. They are increasingly being replaced by private investors, including hedge funds and speculators. This shift in the ownership structure could make the world’s largest and most liquid debt market less resilient.
In 2011, China’s official holdings of US Treasuries were estimated at $1.3 trillion – about 14% of all such securities outstanding. At the time, there were fears that Beijing could use its financial leverage against Washington by selling bonds on a massive scale. That could have sharply increased the cost of servicing US debt, weakened the dollar, and even pushed the US economy into recession.
However, such a scenario appeared unlikely from the outset. It would not have been in China’s interest to undermine its own foreign-exchange reserves and damage the largest market for its exports. A financial catastrophe in the United States would also have seriously harmed the Chinese economy. Mutual dependence effectively restrained both sides from taking radical action.
On the contrary, the substantial presence of China and other central banks had long served a stabilizing function. That protective factor has now almost disappeared.
China reduces its presence in the Treasury market
Major central banks have been reducing their investments in US government securities for years. China’s officially reported holdings of US Treasuries have fallen to $633 billion – less than 2% of all bonds held by the public.
At the same time, some Chinese assets are believed to be held through state-owned banks and offshore structures. The share of foreign central banks in the US government debt market has declined from 40% in 2008 to approximately 12% today.
As conservative, long-term investors – who typically do not react sharply to price changes – have withdrawn, hedge funds have taken over the role of marginal buyers. These private entities are more sensitive to yields, change their positions more quickly, have shorter investment horizons, and often use substantial leverage.
Hedge funds now hold approximately $2.6 trillion in US Treasuries, or more than 8% of the entire market. According to UniCredit, this creates a less stable equilibrium: even a modest increase in bond yields could trigger margin calls and the forced unwinding of leveraged positions.
The true scale of hedge fund involvement is even greater when short positions are taken into account. At the end of last year, their gross exposure to US Treasuries stood at around $4 trillion. Of that amount, $1.6 trillion consisted of short positions. To finance their trades and raise collateral, the funds borrowed approximately $3 trillion in the repo market.
Since the beginning of 2023, hedge funds’ gross Treasury positions, their repo-market borrowing, and their monthly trading volume in these securities have more than doubled. At the same time, activity is concentrated among a narrow group of participants: approximately 50 of the largest funds control around 90% of the total volume.
The scale of this expansion is striking. The combination of large volumes, high concentration, and substantial leverage creates the potential for systemic stress if several strategies come under pressure at the same time or if severe shocks affect the largest participants.
– Philip J. Monin, Federal Reserve economist and author of the study
Could hedge fund strategies trigger a crisis?
So far, no large-scale collapse has occurred. Fears of a breakdown in the so-called basis trade – a strategy in which funds use substantial leverage to profit from small differences between the prices of Treasury futures and the underlying securities – have not materialized.
Investors, regulators, and government officials are aware of the risks involved. Analysts at Capital Economics believe concerns about the growing role of hedge funds in the US bond market are somewhat overstated. This year, funds have significantly reduced their short positions in futures contracts, and the process is currently unfolding in an orderly manner.
Nevertheless, hedge funds remain far more mobile and highly leveraged participants than central banks managing foreign-exchange reserves. When Treasury prices fall, central banks can, by contrast, increase their purchases of bonds and dollars to maintain the composition of their reserves.
Private investors behave differently: they are more likely to cut losses and sell assets when prices decline. This can intensify a downward spiral in the market, especially when lenders’ collateral requirements are rising at the same time.
Against the backdrop of the largest sell-off in US Treasuries and other government bonds in a decade, a question arises: does the new ownership structure increase the risk that a normal correction could turn into a full-blown crisis? The absence of China as a major, stable buyer may leave the market more vulnerable to sharp and interconnected sell-offs.
Thus, the main threat to US Treasuries is now linked less to a possible political decision by Beijing than to the high concentration, leverage, and speed of action among hedge funds. These factors could turn a minor move in yields into widespread financial stress.
