Experts say unraveled hedge fund bets may have fueled the recent slump and rise in yields on European government bonds. Central bankers have been warning for years.
Frankfurt. A “brutal movement” – and a pace that is cause for concern: this is how bond experts classify the recent sell-off in European government bonds. The situation eased somewhat on Tuesday: the price of the ten-year French bond rose, while the yield fell from around 4.9 percent at the end of last week to 4.78 percent. The yield on the ten-year German federal bond fell from just under 3.7 percent to 3.45 percent.
The yield gap between French and German ten-year government bonds, which investors interpret as a risk premium, also fell from a peak of 1.5 percentage points to now 1.32 percentage points. Nevertheless, the level is close to the highs at the time of the Euro sovereign debt crisis in 2011.
Christoph Rieger, chief investment strategist for bonds at Commerzbank, observes great uncertainty among market participants. “Liquidity has increasingly deteriorated in recent days,” he said. There is increasing speculation that hedge funds would have to liquidate positions in the bond market.
The recent sell-off on the bond markets has thus reignited the debate about a development that central banks around the world have been concerned about for years: What are the consequences of the growing influence of so-called shadow banks in trading government bonds - and how do these players behave in a stress scenario?
The term shadow banks is not clearly defined and often has negative connotations: central bank experts at the Bank for International Settlements (BIS), for example, speak of bank-independent financial intermediaries. These are participants in the capital market who do not have a banking license, but whose business model overlaps at least partially with banks.
This broad definition includes bond funds and exchange-traded, index-tracking ETFs, money market funds, pension funds and insurers, but also hedge funds. What all these players have in common is that they hold and trade government bonds.
Shadow banks are the largest creditors in industrialized countries
In a study published at the end of September - just a week before the latest price collapse on the bond markets - BIS researchers Mathias Drehmann and Sonya Zhu note: "Government debt near record levels and the growing influence of financial intermediaries outside the banking sector have shaped the market for government bonds in recent years."
Accordingly, bank-independent financial intermediaries are by far the most important investor and therefore also the most important creditor in the 24 leading industrialized countries - ahead of banks, domestic central banks and other foreign government investor groups. Compared to 2021, investors have particularly compensated for the loss of demand for government bonds due to central banks' balance sheet reduction programs. Banks, on the other hand, have hardly increased their holdings of government bonds.
The BIS researchers come to two worrying results in their analysis:
“High government debt generally worsens future liquidity conditions.”
“A strong presence of non-bank financial intermediaries can contribute to liquidity in good times, but can be detrimental in bad times as they then act as shock amplifiers.”
There are many reasons why shadow banks can intensify a sell-off: mutual funds and money market funds, for example, offer their investors daily liquidity. When government bond prices fall, investors can withdraw funds: This forces fund managers to sell bonds in order to repay investors' money. In extreme cases, fire sales occur, the BIS researchers conclude.
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Hedge funds increase risks for European government bonds
Life insurance companies, in turn, use bond derivatives to hedge long-term liabilities. During strong market movements, they may be forced to unwind these hedging strategies, which can exacerbate market dislocations. According to the BIS researchers, this became apparent in the British bond market around 2022, when investors reacted in shock to Prime Minister Liz Truss' mini-budget.
Risky hedge fund strategy creates selling pressure in stressful periods
And finally, hedge funds have also become increasingly important as buyers of government bonds. According to the BIS, hedge funds have a 50 percent market share in electronic trading of European government bonds. This does not include purchases and sales carried out over the telephone, which are still common in the bond market.
A popular trading strategy is the so-called basis trade, in which hedge funds exploit small price differences between bond derivatives, such as swaps or futures, and the bonds themselves. To ensure that bets on price differences in the cent range pay off, hedge funds typically use a high level of leverage.
However, if short-term interest rates and thus the costs of the necessary borrowed capital rise significantly, hedge funds have to unwind their bets, which puts pressure on bond prices and causes risk premiums to skyrocket.
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According to experts such as Commerzbank chief analyst Rieger, the unwinding of such hedge fund strategies at the end of last week may have increased market movements. It would be a scenario that researchers at the European Central Bank (ECB) have been warning about for more than two years.
In a September 2024 ECB blog post, they write: "While hedge funds' high trading volumes in normal times can help reduce shortages and improve market liquidity, a sudden withdrawal of hedge funds from government bond markets during periods of stress could put pressure on banks and lead to trading bottlenecks."
French central bank chief exudes confidence
If the sell-off on the bond market continues, outflows to money market and bond funds and reactions from other non-bank financial intermediaries could further increase the selling pressure. In any case, the ECB seems alarmed: Commerzbank expert Rieger sees “signs that developments on the bond market are not leaving the ECB indifferent,” for example at an appearance by central bank chief Christine Lagarde in Brussels last week.
French central bank chief Emmanuel Moulin tried to calm markets in an interview with the Financial Times on Monday. He described the recent turmoil in the bond market as “serious and worrying.”
At the same time, however, Moulin expressed confidence that the French government can implement extensive austerity measures in the national budget in the face of political resistance. “France is not Greece during the euro crisis,” he emphasized.
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ECBCommerzbankFranceLiz Truss
Despite the slight relaxation on Tuesday, Christoph Reichmuth, personally liable partner of the Swiss private bank Reichmuth, is of the opinion that the crisis is not over. He said: “The financial markets usually only become interested in government debt when it is already too late.”
Deficits could grow and debts could accumulate over years without investors reacting. “But at some point the perception changes,” he warned. Then the focus would no longer be on the causes but on the financing costs. “France is approaching such a point,” expects the banking expert. He therefore expects the “next stress test for the euro”.
More: Problem cases France, Italy and Spain – The next euro crisis could be imminent
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