New questions are raised about the risks that hedge funds’ activities pose to financial system stability given the increasing importance of non-bank financial intermediaries, according to a paper released Tuesday by the Treasury’s financial research arm.
The paper, according to Treasury’s Office of Financial Research (OFR), looks at the role that changes in hedge fund exposures play in driving U.S. Treasury prices and the yield curve. The agency said it used confidential hedge fund data from the Securities and Exchange Commission (SEC) to calculate hedge funds’ aggregate, net Treasury exposures and their fluctuations over time.
“The authors found significant and robust evidence that changes in hedge fund exposures are related to Treasury yield changes,” the agency said. “Furthermore, the working paper shows that particular strategy groups and lower-levered hedge funds display a larger estimated price impact on Treasuries. Finally, asset pricing tests show that U.S. Treasury investors demand additional return compensation due to risks associated with hedge fund demand.”
The agency said the paper’s findings indicate that trading activities of hedge funds can be linked to market price movements. However, it noted, the findings do not show that hedge funds are the sole or decisive driver of price fluctuations in the Treasury market – nor necessarily the source or originator of fundamental shocks that cascade through the financial system.
“Clearly, there are other forces that drive price movements in those markets,” the paper concludes. The OFR said “it might be difficult to demonstrate” that hedge fund trading during March 2020 – when the financial impact of the coronavirus crisis became apparent in financial markets, causing turbulence – was the principal force behind the large fluctuations in Treasury yields and the decrease in liquidity. “However, they might have served the role of an amplification mechanism,” the paper states.
Hedge Funds and Treasury Market Price Impact: Evidence from Direct Exposures