Central Bank Backstops Fuel Leverage as Treasury Holdings Hit $2.4 Trillion

Central banks' rescue tools are creating the very vulnerabilities they were designed to prevent.

Central banks' crisis backstops are quietly subsidizing government borrowing and fueling leverage, with hedge fund holdings of US Treasuries quadrupling to $2.4 trillion over a decade, Bank of England Chief Economist Huw Pill said.

"Ironically, vulnerability is created by mechanisms that were introduced to reduce vulnerability," Pill said in an interview, likening the cycle to a game of whack-a-mole.

Dallas Fed estimates show hedge funds held $2.4 trillion of Treasuries at the end of 2024, up from $600 billion a decade earlier. Because profit margins on basis and swap arbitrage trades are razor-thin, funds employ leverage of up to 100 times. The 2020 Treasury basis trade blowup forced the Fed to intervene urgently, while signs of swap-market turbulence in 2025 pushed President Trump to retreat from tariffs.

The implicit guarantee that government funding markets will stay liquid keeps yields lower than they would otherwise be, effectively subsidizing sovereign borrowing — until a sharp market turn forces leveraged positions to unwind and central banks to intervene again, reinforcing the next buildup of risk.

The Implicit Subsidy Chain

Pill spelled out the logic: "There's a large amount of UK government debt that needs to be absorbed. How do you support purchases of that debt? Make it attractive." Market imperfections create arbitrage opportunities, but profits are small, so leverage must be allowed to build. "It's good for the government, because it can sell gilts at lower yields. It's good for the financial industry, because they can extract rents from it. It's good for the central bank, because the market looks liquid and functioning. But all of those things are true until they're not true."

Pill worries this implicit guarantee "seeps into" monetary policy, depressing bond yields by stimulating borrowing and weakening the impact of tightening. The legacy of quantitative easing compounds the problem: the massive bond purchases of 2020 stabilized markets but left excess liquidity that became a "powder keg" after Russia's invasion of Ukraine triggered an energy crisis, fanning inflation and complicating the subsequent tightening cycle.

Searching for a Modern Bagehot

Pill points to the Bank of England's "temporary, targeted" gilt purchases during Britain's September 2022 pension-fund crisis as a successful model — the central bank broke the forced-selling spiral without abandoning its monetary tightening stance. The challenge is designing facilities that restore liquidity in emergencies without providing a standing guarantee that rewards excessive risk.

Moral hazard is nonetheless increasing. During the 2023 US banking crisis, the Fed accepted Treasuries as collateral at face value rather than market value, effectively giving banks excess support. The emergency facility then became a funding channel that even healthy banks tapped, easing policy by the back door and forcing the Fed to tighten terms before it expired. Japan is now planning to use the Fed's emergency lending facility to raise cash to support the yen without selling its Treasury hoard.

Pill is calling for a modern version of Bagehot's Principle — the 19th-century doctrine that central banks should lend freely against good collateral at a penalty rate, providing crisis liquidity while curbing moral hazard. Extending that principle to modern bond markets, however, still lacks a clear framework. "I don't know how to break the cycle of crises needing rescues that lead to more leverage and new crises," James Mackintosh, the Wall Street Journal columnist who reported the analysis, wrote. "I'm concerned we're firmly into the added-leverage phase of the latest cycle."

At least central bankers are still thinking about the problem, even if they don't yet have good answers.

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