The next financial crisis may already be underway, but not where many expect

A growing number of traders, academics and bond-market gurus are concerned that the $24 trillion market for US Treasury loans could be headed for a crisis as the Federal Reserve kicks its “quantitative tightening” into high gear this month.

With the Fed doubling its pace to “roll off” the balance sheet of its bond holdings in September, some bankers and institutional traders worry that already thin liquidity in the Treasury market could set the stage for an economic catastrophe. is – or, fall short of that, involves a host of other shortcomings.

In the corners of Wall Street, some are pointing out these risks. A particularly stern warning came earlier this month, when the Bank of America BAC,
Interest rate strategist Ralph Axel warned the bank’s clients that “the decline in the liquidity and resilience of the Treasury market is one of the biggest threats to global financial stability today, possibly worse than the housing bubble of 2004-2007.”

How can a normally stable Treasury market be zero for another financial crisis? Well, treasuries play an important role in the international financial system, their yields making it a benchmark for trillions of dollars in debt, including most mortgages.

Worldwide, the 10-year Treasury yield TMUBMUSD10Y,
is considered the “risk-free rate” which determines the baseline by which many other assets, including stocks, are valued.

But outsize and erratic moves in Treasury yields are not the only issue: as bonds themselves serve as collateral for banks seeking short-term financing in the “repo market” (often described as the “beating heart” of the US financial system). are used. It is possible that if the Treasury market seizes again — as it has almost done in recent times — various credit channels, including corporate, domestic and government lending, “will be closed,” Axel wrote.

See: Stock-market wild card: What investors need to know as Fed shrinks balance sheet at rapid pace

Less than an all-out blowup, liquidity thinning comes with a number 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. There is a possibility that the federal government could default on its debt if the auction of newly issued Treasury bonds stops working properly.

Lack of liquidity has already been an issue since the Fed allowed itself to shrink its massive nearly $9 trillion balance sheet in June. But this month, the pace will hit $95 billion a month, according to a pair of Kansas City Fed economists who published a paper about these risks earlier this year, at an unprecedented pace.


According to Kansas City Fed economists Rajdeep Sengupta and Lee Smith, other market participants that could help compensate for an otherwise less active Fed are already at or close to that in terms of their Treasury holdings.


This could push liquidity further, until another class of buyers arrives – making the Fed’s current period potentially far more chaotic than the previous episode, which happened between 2017 and 2019.

“This qt [quantitative tightening] The episode could play out quite differently, and it probably won’t be as calm and quiet as the previous episode began,” Smith said during a phone interview with Marketwatch.

“Since the balance sheet space of banks is less as compared to 2017, it is more likely that other market participants will have to step in,” Sengupta said during the call.

Sengupta and Smith said that at some point, the higher yield should attract new buyers. But it’s hard to say how higher yields will go before that happens — although as the Fed pulls back, it looks like the market is about to find out.

‘Liquidity is too bad right now’

To be sure, Treasury market liquidity has been declining for some time now, with a number of factors playing a role, even though the Fed was still raising billions of dollars in government debt per month, something it did in March. was closed.

Since then, bond traders have typically noticed unusually wild swings in a more stable market.

In July, a team of interest rate strategists at Barclays BARC,
The signs of thinning treasury markets were discussed in a report prepared for the bank’s clients.

These include wide bid-ask spreads. The spread is the amount that brokers and dealers charge to facilitate a trade. According to economists and academics, shorter spreads are usually associated with more-liquid markets, and vice versa.

But wide spreads aren’t the only symptom: Trading volumes have dropped significantly since the middle of last year, the Barclays team said, as speculators and traders increasingly turn to Treasury futures markets to take short-term positions. According to data from Barclays, the average total nominal Treasury trading volume every four weeks declined from about $3.5 trillion in early 2022 to just over $2 trillion at the beginning of 2022.

At the same time, the depth of the market – that is, the dollar amount on offer through dealers and brokers – has deteriorated significantly since the middle of last year. The Barclays team illustrated this trend with a chart, which is included below.

Source: Barclays

Other measures of bond-market liquidity confirm the trend. For example, the ICE Bank of America Merrill Lynch Move Index, a popular gauge of underlying bond-market volatility, was above 120 on Wednesday, a level indicating that options traders are ready for further auctions in the Treasury market. The gauge is similar to the CBOE Volatility Index, or “VIX,” a Wall Street “fear gauge” that measures expected volatility in equity markets.

The MOVE index peaked at around 160 in June, not far from the 2020 peak of 160.3 seen on March 9 of that year, the highest level since the financial crisis.

Bloomberg also maintains an index of liquidity in US government securities with maturities of more than one year. The index is higher when Treasuries are trading beyond “fair value,” which typically occurs when liquidity conditions deteriorate.

It was at around 2.7 on Wednesday, around its highest level in more than a decade, if one excludes the spring of 2020.

Thin liquidity has had the greatest impact along the short end of the Treasury curve – since short-debt Treasuries are generally more susceptible to Fed interest rate hikes as well as changes in inflation outlook.

In addition, “off the run” Treasuries, the term used to describe all but the most recent issues of Treasury bonds for each period, have been more affected than their “on the run” counterparts.

Because of this thin liquidity, traders and portfolio managers tell MarketWatch that they need to be more careful about the size and timing of their trades as market conditions become increasingly volatile.

John Luke Tyner, Portfolio Manager, Aptus Capital Advisors, said, “Liquidity is very poor right now.

“We’ve had four or five days in recent months where the two-year treasury has moved more than 20″ [basis points] In one day. It’s definitely an eye-opener.”

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.

importance of being liquid

Treasury debt is considered a global reserve asset – just as the US dollar is considered a reserve currency. This means that it is widely held by foreign central banks that need access to dollars to help facilitate international trade.

To ensure that Treasuries maintain this position, market participants must be able to trade them quickly, easily and cheaply, Fed economist Michael Fleming wrote in a 2001 paper titled “Measuring Treasury Market Liquidity”. was.

Fleming, who still works at the Fed, did not respond to a request for comment. But the interest rate strategist at JPMorgan Chase & Co. JPM,
Credit Suisse CS
And TD Securities told MarketWatch that maintaining adequate liquidity is just as important today — if not more so.

Treasury reserve status provides the US government with myriad benefits, including the ability to finance large deficits relatively inexpensively.

What can be done?

When chaos broke out in global markets in the spring of 2020, the Treasury market was not spared from the fall.

The result came surprisingly close to seizing global credit markets, the Group of 30 Working Group on Treasury Market Liquidity explained in a report recommending strategies for improving the functioning of the Treasury market.

As brokers pulled liquidity out of fear of being saddled with losses, the Treasury market saw massive moves that made little sense. The yield on Treasury bonds of the same maturity remained completely unchanged.

Between March 9 and March 18, the bid-ask spread exploded and the number of trades “failed” – which is when a booked trade fails to settle because one of the two counterparties has Doesn’t make money, or assets – increases at roughly three times the normal rate.

The Federal Reserve eventually ran to the rescue, but market participants were given notice, and a group of 30 decided to find out how these market downturns could be avoided.

The panel, led by former Treasury secretary and New York Fed chairman Timothy Geithner, published its report last year, which included a number of recommendations to make the Treasury market more resilient in times of stress. A group of 30 representatives were unable to make any authors available for comment when contacted by Marketwatch.

Recommendations include establishing universal clearing of all Treasury trades and repos, establishing regulatory leverage ratios, allowing dealers to warehouse more bonds on their books, and establishing permanent repo operations at the Federal Reserve.

While most of the recommendations of the report are yet to be implemented, the Fed established permanent 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 Fed facilities didn’t go far enough.

On Wednesday, the Securities and Exchange Commission is preparing to announce that it will propose rules to help improve how Treasuries are traded and approved, including ensuring that more Treasury trades are made. Centrally approved, as recommended by the Group of 30, as MarketWatch reported.

SeeSEC ready to push reforms to tackle next crisis in $24 trillion market for US government debt

As noted by Group of 30, SEC Chairman Gary Gensler has expressed support for the expansion of centralized clearing of Treasuries, which will help improve liquidity in times of stress to ensure that all trades are unhindered. Get settled in times of any hiccups.

Still, if regulators seem complacent when it comes to addressing these risks, it’s probably because they expect the Fed to simply ride to the rescue if something goes wrong. is in the past.

But Bank of America’s Axel believes this notion is misleading.

“It is not structurally sound for US public debt to become increasingly dependent on Fed QE. The Fed is the lender of last resort to the banking system, not the federal government,” Axel wrote.

—Vivian Lu Chen contributed reporting

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