One the primary discussions at the International Monetary Fund and World Bank meetings in Washington this week has been how the United States’ attempt to rebalance the global economy through a trade shock triggered a deleveraging of the hedge fund basis trade.
The unwinding of that trade, which may be larger than $1 trillion, highlights a well-known but little understood risk across the global financial system linked to shadow banks.
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Although the focus at the meetings has been on the trade conflict, one should not discount the possibility of further financial volatility because of the leverage of non-financial bank intermediaries.
Leverage in the nonbanking sector has continued to increase, and the Federal Reserve’s Financial Stability Report for 2024 explicitly noted that “measures of hedge fund leverage increased in the third quarter of 2023 to the highest level observed since the beginning of data availability, with the increase driven primarily by the largest hedge funds.”
Given the large increase in equity valuations since then, that leverage has almost certainly increased notably in the interval.
The condition of nonbank financial intermediaries remains a focus of risk as the direction of the trade war remains uncertain. Traditional banks, which lend to the nonbank intermediaries, would face a liquidity squeeze and interest rates would soar if Washington were to push forward with an aggressive set of tariffs.
More than 16% of total loans are made to nonbank financial intermediaries, according to the IMF, while loans as a percentage of common equity Tier One capital are equal to or greater than 120%.
Another round of deleveraging triggered by margin calls and other liquidity needs would send U.S. rates soaring once again, which would be accompanied by further devaluation of the dollar.
Assets under management of leveraged hedge funds have doubled over the past decade, according to the IMF. While many hedge funds do not employ elevated levels of aggregate exposure, leverage is high in macro and relative value fixed-income strategies that are in aggregate 40 and 25 times their asset values, respectively.
Multi-strategy funds maintain gross notional exposure more than 15 times their asset values.
All have significant exposure to interest rate markets while interest rate derivatives account for almost half of the total gross national exposure of derivatives and repurchase agreements that are favored by macro, relative value fixed-income and multi-strategy hedge funds.
