MNI: BOC Says Hedge Funds Threaten Government Bond Stability

Canada’s government bond and repo markets face risk of strain if hedge funds holding increased amounts of those assets make another dash for cash in response to volatile U.S. trade policy, the BOC warned Thursday.

“The growing presence of hedge funds in the market for Government of Canada bonds raises some concern,” Senior Deputy Governor Carolyn Rogers said. “Hedge funds have also taken on increasingly large amounts of leverage to fund their purchases of government bonds. This makes them more likely to pull back from these crucial markets in periods of stress, introducing added volatility.” Governor Tiff Macklem and Rogers will hold a press conference at 11am EST.

Hedge funds now buy almost half the securities at some government debt auctions and account for 30% of some secondary market trading, the Bank said. In a dash-for-cash “banks could also cut back on their intermediation services to protect their balance sheets -- further disrupting the supply of liquidity when market participants need it most.”

U.S. Treasuries recently weakened alongside stock markets in contrast their usual safe-haven role, the Bank noted, saying that may have reflected nervous hedge fund activity. American policies now represent the biggest risk to Canada, the report said, a shift from years where the main threat was indebted households.

"As the policies of the US administration disrupt global trade, they could also reshape the international financial and monetary system. "There are signs that investors have been re-balancing some of their exposure away from US assets toward other markets," the Bank said. "Such adjustments could lead to sharp increases in the risk premium that investors require to hold US assets. Drastic shifts in global financial flows have the potential to disrupt liquidity in core funding markets and cause stress across the global financial system."

For Canada, "permanent tariffs could cause high unemployment and business insolvencies that result in defaults on household and business debt. This would lead to credit losses for banks and would test the financial system’s resilience," the report said. Stress testing showed that even in a seven-quarter recession bank capital would remain above regulatory minimums, officials found.

Households without a mortgage have emerged as a source of concern, while worries have declined around mortgage holders refinancing five-year fixed-rate loans at higher rates, the Bank said. Household debt as a percentage of disposable income remains elevated but has declined, the Bank said. Part of that is because even though interest rates are still higher for some borrowers who are refinancing, the Bank began cutting rates in June and kept going until a hold last month. 

"The Canadian financial system is resilient," Rogers said. "Despite high indebtedness and the economic turbulence of the pandemic, households, businesses and banks weathered a rapid rise in interest rates. That was a big test, and the financial system proved to be a source of stability."

Officials will continue watching the growing role of hedge funds. "It is increasingly important for them to have robust funding agreements and sufficient liquidity to weather periods of market stress. The Bank will continue to monitor conditions for markets and market liquidity as well as the use of leverage by NBFIs," non-bank financial intermediaries, the report said. The BOC isn't a direct bank regulator but oversees payment systems and runs government debt auctions.

Increased hedge fund participation may also come from the surge in bond supply as governments ran record deficits during the pandemic and have yet to present a plan to return to balanced budgets. Over the last decade some investors also bought in because they see CAD as a reserve currency. Some economists warn more foreign buying of Canada bonds adds another layer of flight risk.