The BIS’s Annual Economic Report 2025 says prospects for the global economy have become much more uncertain and unpredictable in recent months, with trade disruptions roiling financial markets.
- Heightened policy uncertainty and fraying trade ties have weakened the growth outlook, while existing vulnerabilities compound the risks and make economies more prone to inflation pressures.
- While central banks focus on price stability, governments must support structural reforms and manage public finances sustainably to foster growth to meet future needs.
- The increased role of non-banks, including a shift towards financing public debt, brings stronger international transmission of financial conditions and also financial stability risks.
- Trade tensions and heightened uncertainty cloud the outlook for growth and inflation and risk exposing deeper fault lines in the global economy and financial system, the Bank for International Settlements said in its flagship economic report. It called on policymakers to step up as a stabilizing force.
The report analyses vulnerabilities in the real economy and financial system including:
- Shifts towards greater economic fragmentation and protectionism, further exacerbating the decades-long decline in economic and productivity growth across many economies.
- Scars from the post-pandemic inflation surge, which could leave a lasting imprint on household inflation expectations.
- High and rising public debt, increasing the financial system’s vulnerability to interest rate rises while reducing governments’ ability to respond to new shocks.
The report also presents the results of a deep dive into global financial conditions. Structural shifts in the global financial system have led to tighter links between financial markets, reflecting the rapid growth of sovereign bond markets and a bigger role for non-banks such as investment and hedge funds. The greater connectedness is underpinned by the expansion of FX swap markets that allow asset managers to invest globally while hedging currency risk.
Shifting financial intermediation
A key risk today is liquidity stresses in government bond markets. Hedge funds, in particular, have become signficant providers of procyclical liquidity in government bond markets, often employing highly leveraged relative value trading strategies. By using government securities as collateral in the repo market to borrow cash for additional securities, these strategies boost returns but are also vulnerable to adverse shocks in funding, cash or derivatives markets.
This vulnerability has increased further as financing terms have become increasingly lax. Haircuts have gone to zero or even negative in large sections of the repo market, meaning that creditors have stopped imposing any meaningful restraint on hedge fund leverage. This higher leverage leaves the broader market more vulnerable to disruptions, as even slight increases in haircuts can trigger forced selling and amplify financial instability. Such adverse dynamics were on display, for example, during the market turmoil of March 2020, and contributed to the volatility spike in Treasury markets in early April 2025.
The increased heft of hedge funds is reflected, for instance, in their growing US Treasury gross exposure – now exceeding 10% of the outstanding free float – and the expansion of the US repo market segment catering to leveraged investors.
More recently, a more orderly unwinding of relative value trades – this time tied to interest rate swap markets, where investors had bet on a narrowing in spreads due to potential deregulation – seems to have contributed to the heightened volatility observed in Treasury markets in early April 2025.
Stablecoins and USTs
Another potential source of liquidity risk stems from the growing presence of stablecoins in the Treasury market. Although relatively small in terms of aggregate capitalization, some major issuers, such as Tether and Circle, hold significant reserves in US Treasuries and provide substantial repo market funding through dedicated money market funds.
Their increasing heft raises financial stability concerns, as it exposes traditional finance to the ebbs and flows of the crypto ecosystem. On the one hand, as stablecoins grow, they will absorb an increasing share of safe assets that traditional financial institutions could otherwise use. On the other hand, negative shocks in the crypto market could lead to sizeable sell-offs which could disrupt the orderly functioning of Treasury markets.
Finadium previously reported on a special chapter of the report that highlights repo’s significance for central bank tokenization strategies.