The Bank of England's deputy governor stepped in front of cameras to announce that hedge funds might cause a bond market shock. Might. He used the word might. A central banker stood up and said something could maybe happen and expected people to care.
Hedge funds have been using basis trades. They borrow money to exploit tiny price differences between cash bonds and futures contracts. The leverage ratio hit 50-to-1 in some cases. That means when the trade goes wrong, it goes wrong fast. The deputy governor looked at this and thought, "I should warn people." He did not think, "I should stop this." Those are different thoughts.
The Bank of England saw this exact scenario play out in 2020 when liability-driven investment funds nearly collapsed the gilt market. They learned nothing. The hedge funds learned nothing. The only people who learned anything were retail traders, who learned they should definitely put their life savings into 3x leveraged bond ETFs because a guy on YouTube said interest rates have nowhere to go but down.
Here's what happens next. The deputy governor goes back to his office. Hedge funds keep running 50-to-1 leverage on basis trades. Bond prices stay boring until they don't. Then everyone acts surprised. Politicians demand answers. Regulators promise reforms. Hedge funds pay a fine worth 0.3% of what they made. The cycle repeats.
Retail traders will somehow lose money on both sides of this trade. They will buy bond funds at the peak and sell them at the bottom, then buy inverse bond ETFs just in time for the bounce. It's a skill, really. Takes years of practice to be that consistently wrong.
The deputy governor warned us. He did his job. He can sleep well tonight knowing he said the words "systemic risk" into a microphone. The rest of us can sleep well knowing that when the bond market implodes, at least someone said might beforehand.
Photo by Maxim Hopman on Unsplash
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