Global governments face the risk of a sharp increase in borrowing costs driven by potential bond market disruptions, according to the Bank for International Settlements (BIS). The institution, often referred to as the “central bank of central banks,” cautioned that leveraged hedge funds and other non-bank investors could trigger sudden liquidity shortages in government bond markets, threatening fiscal stability worldwide.

In its annual report published on Monday, the BIS identified a new “fiscal-financial stability nexus” where high public debt levels intersect with the growing influence of shadow banking entities such as hedge funds, pension funds, and asset managers. These investors often use leverage to hold significant amounts of government bonds, increasing market vulnerability to rapid sell-offs or “fire sales.” Such events can cause liquidity to evaporate quickly, sharply driving up the cost of government borrowing.

The report pointed to the 2022 mini-budget episode in the United Kingdom as a recent example of this dynamic. In response to then-Prime Minister Liz Truss’s plans for tax cuts paired with increased borrowing, the UK experienced a rapid surge in yields on long-dated gilts, marking the steepest rise in 30-year bonds in two decades. This turmoil compelled the Bank of England to intervene by purchasing government debt and raising interest rates by 0.75 percentage points to restore market calm.

“Financial stresses can now propagate quickly and broadly through funding markets, across borders and between banks and non-banks,” the BIS said. The institution warned that while government bond market liquidity may appear sufficient for extended periods, it can dissipate suddenly, causing fiscal space to contract even before debt levels reach limits implied by long-run economic fundamentals.

Pablo Hernández de Cos, the BIS general manager, emphasized that while the traditional link between banks and sovereign governments has lessened due to strengthened banking regulations, the spotlight has shifted toward the role of shadow banking in government debt markets. He called for regulators to address the exposure of these non-bank entities to sovereign bonds, highlighting that the largest seven advanced economies have recently faced their worst trading periods in government debt markets since before the 2008 financial crisis. This downturn is driven by concerns over persistent inflation, rising interest rates, and questions about public finance sustainability, particularly in the United States.

The BIS also noted that expectations of central bank interventions in bond markets, such as emergency purchases, pose risks of moral hazard. While such actions can stabilize markets in the short term, they may encourage excessive risk-taking by financial intermediaries and weaken fiscal discipline among governments. Moreover, in an environment of elevated inflation, these interventions could complicate central banks’ efforts to achieve price stability.

The report underscores the need for vigilance among global central banks and regulatory bodies to monitor and mitigate vulnerabilities arising from complex interactions between public debt markets and non-bank investors, particularly as governments depend heavily on these markets for financing.