Global central bank warns of Liz Truss-style bonds crisis

Governments across the world are confronting a renewed danger in bond markets, with the Bank for International Settlements warning that heavy public borrowing, leveraged hedge fund activity and fragile market liquidity could combine to trigger a sudden jump in funding costs reminiscent of the UK gilt turmoil under Liz Truss.

In its annual report, the Basel-based institution, often described as the central bank of central banks, said the international financial system was becoming more exposed to a “fiscal-financial stability nexus” in which stress in sovereign debt markets could spill rapidly into the real economy and back into government finances. The warning reflects growing concern among central bankers that the structure of modern bond markets has changed in ways that make them more vulnerable to abrupt, disorderly selling.

The BIS said the combination of high public debt and the growing role of leveraged non-bank financial institutions, especially hedge funds, had created “new vulnerabilities” for governments dependent on investors to fund their deficits. It argued that while bond markets may appear calm for long periods, liquidity can disappear with little warning, causing yields to spike and borrowing costs to rise sharply, often before debt metrics have approached levels that would once have been considered dangerous.

The concern is not abstract. Britain provided the most dramatic recent example in 2022, when the Truss government’s mini-budget, which included unfunded tax cuts and a larger borrowing requirement, sparked a sell-off in long-dated gilts. Yields on 30-year government debt rose at their fastest pace in two decades, forcing the Bank of England to intervene by buying bonds to stabilise the market and prevent a wider financial crisis. The episode exposed the fragility of a market that had long been assumed to be among the safest and most liquid in the world.

The BIS said the same kind of dynamic could now unfold elsewhere, particularly in advanced economies where debt levels are high and investor sentiment is increasingly sensitive to inflation, interest rates and concerns about fiscal credibility. Its warning comes at a time when government bond markets in the G7 have endured their weakest trading conditions since before the global financial crisis, with investors dumping short, medium and long-term debt amid fears that high inflation and higher interest rates may persist while public finances remain under strain.

One of the central concerns is the role of hedge funds and other leveraged investors, who have become important buyers of government bonds. These funds often borrow heavily to increase returns on relatively small price movements, a practice that can magnify gains in stable markets but accelerate losses when prices fall. If volatility rises and lenders demand additional collateral, these investors may be forced to sell bonds quickly, deepening the decline and creating a self-reinforcing spiral. What may begin as a routine adjustment in market pricing can therefore become a fire sale.

The BIS said that financial stresses now have the capacity to propagate “quickly and broadly through funding markets, across borders and between banks and non-banks”. That is a notable shift from the pre-crisis era, when the principal fear was the interaction between banks and sovereign states. Since then, tighter banking regulation has reduced some of those risks inside the core banking system, but it has also pushed activity into less regulated corners of finance, including pension funds, private equity, hedge funds and asset managers. The result is a different kind of fragility, one that is harder for regulators to monitor and often more difficult to contain once it has begun.

In the BIS’s view, this means governments cannot assume that sovereign bond markets are immune from sudden dysfunction simply because they borrow in their own currency or have historically strong credit reputations. It warned that fiscal space can shrink well before debt reaches the limits implied by long-run fundamentals if investors begin to lose confidence and liquidity dries up. In practical terms, that means a country can be forced to pay much more to borrow, not because its debt has suddenly become unsustainable in an accounting sense, but because markets no longer believe they can exit positions smoothly.

The report also addressed the question of how central banks should respond if such disorder emerges. During the UK gilt crisis in 2022, the Bank of England stepped in as a buyer of last resort, restoring calm after pension funds were pushed to the brink by their liability-driven investment strategies. That intervention was effective in the narrow sense, but the BIS cautioned that expectations of rescue can create moral hazard. If investors believe central banks will always step in, they may take greater risks, while governments may feel less pressure to keep borrowing under control. In an inflationary environment, the BIS argued, such interventions can also make central banks’ core task of bringing prices back under control more complicated.

Pablo Hernández de Cos, the BIS general manager, said central bankers should aim to prevent instability at its source by strengthening the supervision and regulation of the non-bank financial sector. In his view, the lesson of recent turmoil is that the next crisis may not begin in the banking system at all, but in the shadow banking world of funds and leveraged traders that now hold large quantities of government debt. The challenge for policymakers, he said, is to reduce the market’s exposure to these institutions without undermining the functioning of sovereign debt markets themselves.

That balance will not be easy to strike. Governments rely on liquid bond markets to finance deficits and roll over debt on a continuous basis, while investors demand enough flexibility to buy and sell at speed. Yet the very openness that makes bond markets efficient also makes them susceptible to sudden withdrawals of liquidity. Years of ultra-low interest rates and central bank asset purchases after the financial crisis encouraged investors to treat government bonds as safe and stable holdings, but the return of inflation and the sharp rise in interest rates have changed that environment. Bonds are once again subject to large price swings, and with those swings comes the possibility of forced selling.

The BIS’s warning also lands at a politically sensitive moment. Across the developed world, governments are under pressure to spend more on defence, energy security, health care and ageing populations, while tax revenues remain under strain. At the same time, voters have shown little appetite for austerity, making it harder for ministers to reduce borrowing. The result is a tension between the demands of politics and the discipline of markets. When confidence holds, governments can postpone difficult choices. When it breaks, bond investors can impose them abruptly.

Britain’s experience in 2022 remains the clearest illustration of how quickly that can happen. What began as a political statement about growth turned into a market crisis with implications for pension funds, mortgage rates and the wider economy. The episode was a reminder that fiscal policy cannot be divorced from market confidence, however loudly ministers may insist otherwise. Once investors decide that a government has lost control of its financing plan, they can force a rapid and painful correction.

The BIS is now arguing that this risk is no longer confined to the margins. Its concern is that the global bond market, long seen as the bedrock of financial stability, may itself have become a source of instability. That is partly because the market is larger and more interconnected than before, and partly because the institutions trading within it are more heavily leveraged and more prone to crowd behaviour. In calmer times, this structure can appear resilient. Under stress, it can turn brittle with startling speed.

For central bankers, the message is uncomfortable. They can no longer assume that the main threats will come from banks or from the familiar channels of credit loss. Instead, they must watch for sudden dysfunction in markets that governments depend on every day but rarely think about until they begin to fail. The BIS is effectively warning that the next sovereign debt shock may not resemble the crises of the past. It may instead arrive as a liquidity event, driven by investors rushing for the door at the same time.

That would have consequences far beyond bond traders. Higher government borrowing costs feed through into public spending decisions, welfare pressures, tax policy and eventually household finances. Mortgages, business loans and asset prices all respond to changes in the sovereign yield curve. A disorderly rise in gilt or Treasury yields is therefore not merely a market story but a broader economic threat, capable of reshaping policy choices and public life. That is why the BIS has placed such emphasis on the problem now.

The institution’s intervention will also be read as a message to politicians as much as to central bankers. In effect, it is saying that fiscal credibility has become more important, not less, in an era when market liquidity can vanish quickly and government bond buyers may include the very funds most likely to head for the exit first. The old assumption that rich democracies can borrow without limit at modest cost is being tested by inflation, interest rates and the growing power of leveraged finance. The warning from Basel is that the test may become harsher still if policymakers fail to adapt.