Mohit Kumar, chief financial economist at Jefferies, says: “Debt is a concern across the board, and it’s not just about me. When I talk to investors the most important question is: if we can achieve a republican sweep what happens? It means Trump has more freedom to do what he wants and we could see the deficit increase.”

Borrowing costs have risen sharply over the past month, with the 10-year Treasury yield rising 63 basis points to 4.36 percent.

High debt levels and interest costs raise questions about the long-term health of the U.S. economy. Will the bond vigilantes punish Washington and impose fiscal discipline, just as they did in Britain after Liz Truss’s mini-budget?

That’s not the only threat looming over US debt markets. In a dark corner of the global market, there is a financial trade that is causing increasing alarm among officials around the world.

house of cards

Hedge funds have created complex trades worth more than $1 trillion based on US debtfinanced by short-term loans from banks and selling them to pension funds.

Trades are not bets on price. Rather, hedge funds are exploiting small gaps in market prices to make money. The margins are small, but when the operations are this large, it all adds up.

It is this magnitude that worries central bankers. The Bank of England noted last month that trade had reached a new high, growing to 1 trillion dollars from a previous record of $875 billion. Officials warned that the trades could trigger a market collapse in a worst-case scenario.

Raphael Gallardo, chief economist at French asset manager Carmignac, says: “This is a risk that deserves attention. It represents something like 3 percent of the total debt of the United States.”

The so-called base trading that raises concerns will sound like jargon to most people. In practice, these are hedge funds that act as intermediaries between pension funds and the United States government.

Hedge funds buy US debt – known as Treasuries – and then sell futures contracts based on that debt to investors such as pension funds at a slightly higher price. Pension funds sometimes prefer these contracts, which are based on the value of a treasury, for various reasons.

“Think of it like the oil market, for example,” Gallardo says. “No one wants to store barrels of oil in their yard. You have the referees doing the job.”

The concern arises from the fact that hedge funds take advantage of the returns from these trades using borrowed money.

“They don’t have the cash to do it all, so their positions are hyper-leveraged. This is actually very dangerous”says Gallardo.

Hedge funds raise the money through so-called repurchase agreements, known as repos, a form of short-term borrowing from big banks. Government bonds are put up as collateral. They then use this money to buy more debt.

While trading itself is complex, it doesn’t take a genius to realize that borrowing against an asset to fund further purchases of that asset is a risky proposition. It could collapse like a house of cards.

“When they buy Treasury bonds in the cash market, they finance them in the repo market,” says Gallardo. “Of course, no one knows how many times the same Treasury bond is repurchased.”

Hedge funds had more than $550 billion in treasury operations backed by just $10 billion of their own cash at the end of 2023, according to Federal Reserve research.

“Can we get a forced relaxation that causes domino effects in the market? That is the big concern,” says Kumar.

Shock waves around the world

The Bank of England’s expert panel tasked with monitoring threats to the UK’s financial system has been watching the operation for some time. They have highlighted several possible triggers that could cause “serious but plausible tensions” in the markets.

One such trigger could be if hedge funds suffered large losses in other investments, leading them to quickly exit treasury trading.

While not exactly the same, the risks of hedge fund basis trading have drawn comparisons to the liability-driven investment crisis that nearly brought down pension funds in the wake of the mini-budget.

Rising bond yields forced pension funds to sell bonds to raise cash to cover operations. However, the bond sale simply triggered further rises in bond yields, restarting the whole process all over again. Ultimately, the Bank of England was forced to intervene to stop a fatal cycle of rising borrowing costs.

US government bonds are considered the ultimate safe-haven asset and back a wide range of financial assets. As a result, the shock waves of any rapid price movement would be felt across the globe and across a wide range of assets. The European Central Bank highlighted this risk in May.

In other words, if one of the world’s safest investments turns out to be dangerous, it would pose a global threat on a historic scale.

Kumar tells the truth risk of such collapse It is difficult to discern. “There is no way to distinguish between saying that this is real money trying to hedge its long position or that it is a speculative hedge fund that is actively doing basis trading. The data seems very confusing.”

When it comes to America’s growing debt, economists disagree about how worried we should be.