Tensions in the $23 billion U.S. government debt market escalate as the Fed tightens monetary policy
Investors’ ability to trade U.S. government debt has deteriorated to its lowest level since the March 2020 turmoil, heightening concerns about the world’s most important bond market as the Federal Reserve tightens monetary policy.
The liquidity, or ease of buying and selling, of US government securities has fallen since the start of this year, reaching levels not seen since the early months of the coronavirus crisis, according to an index compiled by Bloomberg.
Deteriorating trading conditions have exacerbated price swings this month, with investors growing increasingly concerned about the proper functioning of the market as the Fed begins to shrink the size of its $9 billion balance sheet.
Treasuries are already on track to post their worst quarter since at least 1973 after the Fed raised interest rates for the first time since 2018 this month in its bid to tackle inflation, which reached its highest level in 40 years. It also halted its bond buying program in times of crisis.
At the same time, the war in Ukraine has caused several bouts of volatility on Treasuries in recent weeks. Such intense volatility is unusual and concerning in the $23 billion market, widely considered the deepest in global finance, according to traders and investors.
“Liquidity and market functioning issues faded into the background as the Fed entered the market with a huge asset purchase program. [in March 2020]said Gregory Whiteley, portfolio manager at DoubleLine. “Now, with the end of market support from Fed operations and the Fed balance sheet set to start shrinking again, we are seeing the return of market function concerns.”
The Treasury market is the foundation of international finance, so price movements there ricochet off into other markets, affecting everything from mortgage rates to stock prices. The severe turmoil in global markets at the onset of the pandemic in March 2020 was significantly compounded by sharp swings in US government bond prices.
Treasuries typically rally during times of growing market jitters as traders hide their money in the safest assets, but prices have fallen in 2020 as a jolt of risk aversion pushed participants to get out of US public debt. The Fed was forced to intervene to stabilize the market by pledging to buy unlimited amounts of government bonds and taking steps to stimulate the corporate debt market for the first time ever.
With the Fed now rolling back the stimulus it launched at the height of the pandemic, investors fear that long-term issues with the functioning of the Treasury market could make it vulnerable again.
Primary dealers – the 24 financial institutions that are the traditional market makers for Treasuries – have retired from that role since stricter capital requirements were put in place after the 2007-09 financial crisis. Hedge funds and high-frequency trading firms have stepped in to fill the void, but often pull out of the markets during periods of turmoil, a factor that some analysts say increases volatility.
New rules proposed Monday by the Securities and Exchange Commission begin the process of addressing some of these structural issues, but progress has been and should continue to be slow.
According to Mark Cabana, head of US rates strategy at Bank of America, the large price moves in recent days that have occurred with no apparent trigger present a warning of what may be to come. “When I see moves like this happening for no really good reason – against the backdrop of the already fragile workings of the Treasury market, and even before [the Fed starts selling bonds] — it just makes me worried,” he said.
Cabana added that greater volatility could tighten financial conditions, making it more difficult for businesses and consumers to obtain financing, which “could slow the economy down quite significantly.”