Bank of Canada staff paper finds hedge funds did not worsen government bond illiquidity during onset of 2026 Middle East conflict

A Bank of Canada staff paper published Friday found no evidence that hedge funds worsened illiquidity in Canada’s government bond market at the start of the 2026 Middle East conflict, despite a sharp jump in yields and heavy scrutiny of leveraged investors during periods of market stress.

That finding matters because hedge funds have often been cited as a potential source of instability when sovereign bond markets seize up. Past episodes, including the U.S. Treasury market turmoil in March 2020 and the UK gilt crisis in 2022, raised concerns that leveraged trades can unravel quickly and intensify volatility. In Canada’s case, the new study says that did not happen.

The paper, titled “Hedge funds and bond market liquidity dynamics at the onset of the 2026 Middle East conflict,” was published as Staff Analytical Paper 2026-42 by Vincent Meh, Jabir Sandhu and Andreas Uthemann of the Bank of Canada’s Financial Stability Department. The authors wrote: “We find no evidence that they did.”

The study focuses on what it calls the opening phase of the conflict. “We define the onset of the war as the period from its start on February 28th to the end of March 2026,” the paper said. Over that stretch, conditions in the Government of Canada, or GoC, bond market deteriorated and yields climbed sharply. The 2-year GoC yield rose by almost 70 basis points, according to the paper.

Even so, the authors found that hedge funds remained active buyers in the primary market, where new federal bonds are sold at auction. During the onset period, they continued to buy around 40% to 50% of newly issued bonds at GoC auctions.

In the secondary market, where existing bonds are traded, hedge funds moved in the opposite direction. They reduced repo borrowing — a common form of short-term funding used to finance bond positions — and were net sellers of GoC bonds. The paper said the drop in net repo borrowing was the largest monthly decline since January 2020, while net secondary-market sales were the second-largest monthly net selling since then.

But the study says those trades did not amount to evidence of destabilizing fire sales. Instead, the authors said the activity was broadly consistent with hedge funds’ typical relative-value strategies, in which firms trade small price differences between closely related securities.

A key test was whether bond dealers were overwhelmed by client flows. The paper found that dealers’ ability to offset client trades within individual GoC bonds stayed within its usual range of roughly 50% to 60% of total client transactions during the onset period. It also found no statistically significant difference in hedge funds’ cost of immediacy — the gap between a trade price and the interdealer mid-price, a gauge of how expensive it is to transact quickly — compared with the months before or after the shock.

The authors said one reason market functioning held up was that hedge fund selling was met by buying from other asset managers, including pension funds and wealth managers. Those two-sided flows reduced the need for dealers to absorb unusually large bond inventories, helping limit strains on market liquidity.

That makes the Canadian result notable, not routine. In its July 2026 Financial Stability Report, the Bank of England said that after the onset of the same conflict, “moves in gilt yields were amplified by hedge fund deleveraging.”

The Bank of Canada paper, however, is staff research produced independently of the central bank’s Governing Council and reflects the authors’ views alone, not an official policy judgment.

The analysis drew on Department of Finance Canada auction data, the Market Trade Reporting System, Refinitiv Workspace data and Bank of Canada calculations.