Central Bank Backstops Fuel $2.4 Trillion Hedge Fund Leverage

Central banks that became market makers of last resort in the 2008 and 2020 crises now fuel the leverage that could trigger the next one, Bank of England Chief Economist Huw Pill warned.

"The irony is that the vulnerabilities are created by the very mechanisms introduced to reduce them," Pill said in remarks reported by the Wall Street Journal.

Hedge fund holdings of US Treasuries reached $2.4 trillion at the end of 2024, up from $600 billion a decade earlier, according to estimates from the Federal Reserve Bank of Dallas. Funds use leverage of up to 100 times to profit from thin pricing gaps between government bonds and related futures or swaps.

The arrangement lowers government borrowing costs while markets function, but unwinds violently when leveraged positions are forced to sell — as in 2020, when the Treasury basis trade collapse forced Fed intervention, and in 2025, when swap-market stress pushed the Trump administration to retreat on tariffs.

The concern centers on central banks expanding beyond their traditional role as lender of last resort — providing liquidity to banks under stress — to become market makers of last resort, directly intervening in corporate and government bond markets. Such support can stop forced selling from destabilizing markets, but the expectation of intervention reduces perceived risk and encourages investors to take on more debt.

Pill described the mechanism as an implicit subsidy to governments. "There's a large stock of gilts to be digested. How do you support the purchase of those gilts? Make it attractive. How do you make it attractive? There are imperfections in the market that create arbitrage opportunities, but the profits are small. How do you make the profits meaningful? Allow leverage to build up," he said. "That's good for the government because it can sell gilts at a lower yield. It's good for the financial sector because it extracts rents. It's good for the central bank because the market looks liquid and functioning. And it all works — until it doesn't."

Leverage Builds in Treasury Basis Trades

The pattern is most visible in US Treasury markets. Hedge funds held $2.4 trillion of US government debt at the end of 2024, up from $600 billion a decade earlier, according to Dallas Fed estimates. The positions fund basis trades — arbitrage between cash Treasuries and futures — and swap trades, which require leverage of up to 100 times to generate meaningful returns from thin pricing gaps.

The collapse of Treasury basis trades in March 2020 forced the Fed to intervene in markets it had not touched since the 2008 crisis. In 2025, stress in swap markets prompted the Trump administration to retreat on tariff policy, according to the WSJ analysis.

The 2022 Gilt Crisis as a Model

Pill pointed to the Bank of England's temporary gilt purchases during Britain's 2022 pension-fund crisis as a better model. The targeted action stopped forced selling without abandoning the central bank's broader monetary tightening. The challenge, he said, is designing facilities that restore liquidity during emergencies without providing a standing guarantee that rewards excessive risk.

The 2023 US banking crisis offered a cautionary tale. The Fed's emergency lending facility, which accepted Treasuries at face value rather than market value, was later used by healthy institutions as a cheap funding source, effectively loosening monetary policy through the back door. Officials tightened the terms before the facility expired.

Pill also warned that the implicit guarantee could "seep into" monetary policy, stimulating borrowing and lowering bond yields in ways that blunt the effect of tightening. He noted that the excess liquidity left by 2020 quantitative easing became a "powder keg" that amplified inflation after Russia's invasion of Ukraine.

Japan is now planning to use the Fed's emergency lending facilities to support the yen while avoiding sales of its large US Treasury holdings, a move that echoes the pattern.

The WSJ's James Mackintosh acknowledged the difficulty of breaking the cycle. "I don't know how to break the cycle — crises require bailouts, bailouts lead to more leverage, more leverage triggers new crises. I fear we are firmly in the leverage-accumulation phase of the latest cycle," he wrote. At minimum, he said, central bank officials are still thinking about the problem, "even though they don't yet have good answers."

This article is for informational purposes only and does not constitute investment advice.