A growing number of traders, academics, and bond-market gurus are worried that the $24 trillion market for U.S. Treasury debt could be headed for a crisis as the Federal Reserve kicks its “quantitative tightening” into high gear this month.
With the Fed doubling the pace at which its bond holdings will “roll off” its balance sheet in September, some bankers and institutional traders are worried that already-thinning liquidity in the Treasury market could set the stage for an economic catastrophe — or, falling short of that, involve a host of other drawbacks.
In corners of Wall Street, some have been pointing out these risks. One particularly stark warning landed earlier this month, when Bank of America
interest-rate strategist Ralph Axle warned the bank’s clients that “declining liquidity and resiliency of the Treasury market arguably poses one of the greatest threats to global financial stability today, potentially worse than the housing bubble of 2004-2007.”
How could the normally staid Treasury market become ground zero for another financial crisis? Well, Treasuries play a critical role in the international financial system, with their yields forming a benchmark for trillions of dollars of loans, including most mortgages.
Around the world, the 10-year Treasury yield is considered the “risk-free rate” that sets the baseline by which many other assets — including stocks — are valued against.
But outsize and erratic moves in Treasury yields aren’t the only issue: since the bonds themselves are used as collateral for banks seeking short-term financing in the “repo market” (often described as the “beating heart” of the U.S. financial system) it’s possible that if the Treasury market seizes up again — as it has nearly done in the recent past — various credit channels including corporate, household and government borrowing “would cease,” Axle wrote.
Short of an all-out blowup, thinning liquidity comes with a host of other drawbacks for investors, market participants, and the federal government, including higher borrowing costs, increased cross-asset volatility and — in one particularly extreme example — the possibility that the Federal government could default on its debt if auctions of newly issued Treasury bonds cease to function properly.
Waning liquidity has been an issue since before the Fed started allowing its massive nearly $9 trillion balance sheet to shrink in June. But this month, the pace of this unwind will accelerate to $95 billion a month — an unprecedented pace, according to a pair of Kansas City Fed economists who published a paper about these risks earlier this year.
According to Kansas City Fed economists Rajdeep Sengupta and Lee Smith, other market participants who otherwise might help to compensate for a less-active Fed are already at, or near, capacity in terms of their Treasury holdings.
This could further exacerbate thinning liquidity, unless another class of buyers arrives — making the present period of Fed tightening potentially far more chaotic than the previous episode, which took place between 2017 and 2019.
“This QT [quantitative tightening] episode could play out quite differently, and maybe it won’t be as tranquil and calm as that previous episode started out,” said Smith said during a phone interview with MarketWatch.
“Since banks’ balance sheet space is lower than it was in 2017, it’s more likely that other market participants will have to step in,” Sengupta said during the call.
At some point, higher yields should attract new buyers, Sengupta and Smith said. But it’s difficult to say how high yields will need to go before that happens — although as the Fed pulls back, it seems the market is about to find out.
‘Liquidity is pretty bad right now’
To be sure, Treasury market liquidity has been thinning for some time now, with a host of factors playing a role, even while the Fed was still scooping up billions of dollars of government debt per month, something it only stopped doing in March.
Since then, bond traders have noticed unusually wild swings in what is typically a more staid market.
In July, a team of interest-rate strategists at Barclays
discussed symptoms of thinning Treasury market in a report prepared for the bank’s clients.
These include wider bid-ask spreads. The spread is the amount that brokers and dealers charge for facilitating a trade. According to economists and academics, smaller spreads are typically associated with more-liquid markets, and vice-versa.
But wider spreads aren’t the only symptom: Trading volume has declined substantially since the middle of last year, the Barclays team said, as speculators and traders increasingly turn to the Treasury futures markets to take short-term positions. According to Barclays’ data, average aggregate nominal Treasury trading volume has declined from nearly $3.5 trillion every four weeks at the beginning of 2022 to just above $2 trillion.
At the same time, market depth — that is, the dollar amount of bonds on offer via dealers and brokers — has deteriorated substantially since the middle of last year. The Barclays team illustrated this trend with a chart, which is included below.
Other measures of bond-market liquidity confirm the trend. For example, the ICE Bank of America Merrill Lynch MOVE Index, a popular gauge of implied bond-market volatility, was above 120 on Wednesday, a level signifying that options traders are bracing for more ructions ahead in the Treasury market. The gauge is similar to the CBOE Volatility Index, or “VIX”, the Wall Street “fear gauge” that measures expected volatility in equity markets.
The MOVE index nearly reached 160 back in June, which is not far from 160.3 peak from 2020 seen on March 9 of that year, which was the highest level since the financial crisis.
Bloomberg also maintains an index of liquidity in U.S. government securities with a maturity greater than one year. The index is higher when Treasuries are trading further away from “fair value”, which typically happens when liquidity conditions deteriorate.
It stood at roughly 2.7 on Wednesday, right around its highest level in more than a decade, if one excludes the spring of 2020.
Thinning liquidity has had the biggest impact along the short end of the Treasury curve — since short-dated Treasuries are typically more susceptible to Fed interest-rate hikes, as well as changes in the outlook for inflation.
Also, “off the run” Treasuries, a term used to describe all but the most recent issues of Treasury bonds for each tenor, have been affected more than their “on the run” counterparts.
Because of this thinning liquidity, traders and portfolio managers told MarketWatch that they need to be more careful about the sizing and timing of their trades as market conditions grow increasingly volatile.
“Liquidity is pretty bad right now,” said John Luke Tyner, a portfolio manager at Aptus Capital Advisors.
“We have had four or five days in recent months where the two-year Treasury has moved more than 20 [basis points] in a day. It’s certainly eye opening.”
Tyner previously worked on the institutional fixed income desk at Duncan-Williams Inc. and has been analyzing and trading fixed-income products since shortly after graduating from the University of Memphis.
The importance of being liquid
Treasury debt is considered a global reserve asset — just like the U.S. dollar is considered a reserve currency. This means it’s widely held by foreign central banks that need access to dollars to help facilitate international trade.
To ensure that Treasuries retain this status, market participants must be able to trade them quickly, easily and cheaply, wrote Fed economist Michael Fleming in a 2001 paper entitled “Measuring Treasury Market Liquidity”.
Fleming, who still works at the Fed, didn’t respond to a request for comment. But interest-rate strategists at JP Morgan Chase & Co.
and TD Securities told MarketWatch that maintaining ample liquidity is just as important today — if not more so.
The reserve status of Treasuries confers myriad benefits to the U.S. government, including the ability to finance large deficits relatively cheaply.
What can be done?
When chaos upended global markets in the spring of 2020, the Treasury market wasn’t spared from the fallout.
As the Group of 30’s Working Group on Treasury Market Liquidity recounted in a report recommending tactics for improving the functioning of the Treasury market, the fallout came surprisingly close to causing global credit markets to seize up.
As brokers pulled liquidity for fear of being saddled with losses, the Treasury market saw outsize moves that made seemingly little sense. Yields on Treasury bonds with similar maturities became entirely unhinged.
Between March 9 and March 18, bid-ask spreads exploded and the number of trade “failures” — which occur when a booked trade fails to settle because one of the two counterparties doesn’t have the money, or the assets — soared to roughly three times the normal rate.
The Federal Reserve eventually rode to the rescue, but market participants had been put on notice, and the Group of 30 decided to explore how a repeat of these market ructions could be avoided.
The panel, which was led by former Treasury Secretary and New York Fed President Timothy Geithner, published its report last year, which included a host of recommendations for making the Treasury market more resilient during times of stress. A Group of 30 representative was unable to make any of the authors available for comment when contacted by MarketWatch.
Recommendations included the establishment of universal clearing of all Treasury trades and repos, establishing regulatory carve-outs to regulatory leverage ratios to allow dealers to warehouse more bonds on their books, and the establishment of standing repo operations at the Federal Reserve.
While most of the recommendations from the report have yet to be implemented, the Fed did establish standing repo facilities for domestic and foreign dealers in July 2021. And the Securities and Exchange Commission is taking steps toward mandating more centralized clearing.
However, in a status update released earlier this year, the working group said the Fed facilities didn’t go far enough.
On Wednesday, the Securities and Exchange Commission is preparing to announce that it would propose rules to help reform how Treasuries are traded and cleared, including making sure more Treasury trades are centrally cleared, as the Group of 30 recommended, as MarketWatch reported.
As the Group of 30 noted, SEC Chairman Gary Gensler has expressed support for expanding centralized clearing of Treasuries, which would help improve liquidity during times of stress by helping to ensure that all trades settle on time without any hiccups.
Still, if regulators seem complacent when it comes to addressing these risks, it’s probably because they expect that if something does go wrong, the Fed can simply ride to the rescue, as it has in the past.
But Bank of America’s Axel believes this assumption is misguided.
“It is not structurally sound for the U.S. public debt to become increasingly reliant on Fed QE. The Fed is a lender of last resort to the banking system, not to the federal government,” Axel wrote.
—Vivien Lou Chen contributed reporting