Hedge Funds Prop Up US Treasuries as Long-Term Money Dries Up

30-Year Treasury Prices Slump as US Deficit Financing Needs Rise

Central Banks Trim Long-Dated Holdings

Long-Term Investors Cut Exposure to Rate-Sensitive Debt

Short-Term Hedge Fund Money Fills the Gap

Treasury Derivatives Positions Jump 40% in Two Years

Warnings are growing that the US Treasury market's underlying resilience is weakening as the federal budget deficit climbs. A key reason is the dollar's increasing role as a vehicle for earning returns in US capital markets. As large institutions that once held Treasuries for the long term cut back and more short-term, leveraged money flows in, market volatility is rising.

◇ Warning Signs Flash for Long-Term Treasury Yields

Data from the US Treasury Department and the Congressional Budget Office show the government will need to issue $1.8 trillion to $2 trillion of Treasuries this year to finance the deficit. On the surface, the market still looks healthy. Daily trading volume is about $1.2 trillion, and Treasury auctions are drawing $2.30 to $2.50 of bids for every dollar sold.

Under the surface, however, warning signs are mounting. The appeal of long-dated Treasuries, which are typically bought by large investors, has weakened. The 30-year Treasury yield is now 0.5 percentage point above the 10-year yield, up from a 0.2 percentage point gap at the start of 2025.

Longer-dated Treasuries are more sensitive to risk. The Wall Street Journal said the sharp rise in 30-year yields, which means prices are falling, shows investors are increasingly wary of buying bonds amid concern over the US fiscal deficit and the possibility of higher inflation.

Another source of risk is the shrinking role of primary dealers, the large banks and securities firms that have served as a last line of support in Treasury auctions. JPMorgan says primary dealers accounted for 40% to 50% of Treasury purchases across maturities in 2010. That share has fallen to 10% to 15% this year. Including primary dealers, overseas central banks and pension funds, the share held by long-term Treasury investors has dropped to 52% this year from 75% in 2007.

◇ Hedge Funds Add to Volatility

Hedge funds with a short-term trading focus are filling that gap. Unlike long-term investors that buy Treasuries based on confidence in the US government's credit, they typically pursue arbitrage between cash Treasuries and futures.

They usually finance those positions through repurchase agreements, or repos. For example, a fund might use $10 of its own money and borrow another $90 from a bank to buy $100 of Treasuries.

That approach can produce sizable returns from even small price gaps in normal markets. The risks become much greater in a crisis if banks pull back lending. Federal Reserve data show hedge fund positions in US Treasuries, including cash bonds and derivatives, stood at $4.04 billion as of September last year, up 39.8% from $2.89 billion in December 2023. There are concerns that if market stress forces funds to unwind positions and dump Treasuries, the selling could trigger a sharp drop in bond prices and a surge in yields.

◇ Investors Buy US Stocks Instead of Bonds

The dollar's strength against other major currencies is also reducing the bond market's appeal as the greenback increasingly functions as a return-seeking currency. In the past, investors often bought dollars and then moved the money into US Treasuries during periods of dollar strength. More recently, they have been buying US artificial intelligence-related stocks instead.

Higher US real yields, calculated as nominal yields minus expected inflation, are also a negative for long-dated Treasuries. Bonds issued earlier at lower rates become less attractive, pushing prices down.

Bloomberg reported that Wall Street investors are betting on a stronger dollar while cutting holdings of long-dated US Treasuries, which are sensitive to changes in inflation and interest rates. That heightens the risk by reducing the pool of capital willing to absorb government debt steadily.

The Treasury Department's preference for issuing mostly short-dated securities to restrain long-term yields is also viewed as a temporary fix. To refinance existing debt and fund new fiscal deficits, the government will eventually have to sharply increase issuance of 10-year and 30-year Treasuries. If the market cannot absorb that supply smoothly, long-term yields could jump.

The burden on the Fed, which has repeatedly stepped in during periods of fiscal stress, is also increasing. The Wall Street Journal said that widening fiscal deficits, a fragile market structure and reliance on short-term debt have combined to make it more likely that even a small shock could trigger major turmoil in the Treasury market.

Hwang Jung-soo, New York correspondent / Kim Dong-hyun, reporter hjs@hankyung.com