About 18 months ago, some of the world’s most important financial regulators warned of a risk lurking within the arcane plumbing of the US financial system.

The Bank for International Settlements, the US Federal Reserve Board, the Financial Stability Board and the Bank of England all pointed to the risks of financial market turmoil latent in an increasingly popular hedge fund strategy.

Donald Trump took umbrage at remarks by Federal Reserve chair Jerome Powell.Credit: Bloomberg

They were referring to a relative value, or arbitrage, trade – commonly referred to as the “basis” trade – which exploits minor differences in the prices of US government debt securities within physical and futures markets.

Hedge funds buy US Treasury securities, borrow against them in the short-term funding market and then take a short position in the futures market, where prices are generally marginally higher than that of the bonds.

To generate meaningful profits from the minuscule margins in the trade, the funds use financial leverage – lots of it – that is amplified by the synthetic leverage inherent in using the futures market, where the margins they have to fund are fractions of the value of their positions.

That vulnerability in the heart of the US bond market [remains]. Trump’s erratic policy agenda is the potential tinderbox.

The regulators witnessed the near-implosion of the British bond market when former prime minister Liz Truss unveiled a mini-budget containing major unfunded tax cuts. Bond investors revolted; yields soared and the pound plummeted.

The regulators were concerned about the risk of something similar occurring within the US bond market, the world’s most important financial market.

It has. After US President Donald Trump unveiled his baseline and “reciprocal” tariffs this month, there was a near-seizure in the bond market.

Yields spiked as hedge funds scrambled to cash out their positions. There was also a rush to quit US dollar exposures: the dollar slumped against the currencies of America’s major trading partners. The US sharemarket fell heavily.

It is most unusual for bond yields to rise and the dollar to fall during times of financial stress. Traditionally, they have been the world’s........

© Brisbane Times