The flaws in the US Treasury bond market
It should be simple to buy and sell bonds on the biggest bond market in the world. Gregory Whiteley, a bond portfolio manager at DoubleLine Capital, claims that for the majority of this year, it hasn’t exactly been easy.
In this $24 trillion market, a dealer could previously regularly obtain $400 million worth of US Treasury bonds, according to Whiteley. But currently, achieving so usually means dividing the order up into smaller bits; for example, making $100 million of the trade online and then picking up the phone to see if they can wrest the remaining debt from the trading desks on Wall Street over the course of a day.
At the beginning of the coronavirus epidemic, there was a significant fright for the US Treasury bond market as abrupt drops in prices and liquidity were caused by concerns about the world economy collapsing.
The biggest bond market in the world is now stuttering once more as the Federal Reserve struggles to control inflation, a recession approaches, and most asset values have seen a sharp decline.
After seeing a sharp fall over the previous year, market liquidity, one of the most important indicators of how well it is performing, is at its lowest levels since March 2020. According to Jay Barry of JPMorgan, market depth—a metric of liquidity—is also at its lowest point since March 2020. Market depth refers to a trader’s capacity to buy or sell Treasuries without affecting prices.
According to Greg Peters, a co-chief investment officer of PGIM Fixed Income, “markets are in a much more vulnerable state, with awful liquidity.” The likelihood of a financial accident is higher because of how delicate markets operate.
All of this was taking place even before the recent collapse in UK government debt, which has heightened concerns about the shakiness of the world’s major bond markets.
While investors are not worried about a precise repeat of the UK crisis, in which pension funds made significant leveraged bets on the direction of bonds, many are anxious that an unanticipated wave of selling might quickly overwhelm the frail infrastructure of the US bond market.
Steven Major, global head of fixed income research at HSBC, claims that the market jitters in the gilts sector served as a “fire drill” for everyone else. Investors claim that occasionally, rather than the other way around, price volatility in US bonds is caused by a lack of liquidity.
In a speech at the end of this October, US Treasury Secretary Janet Yellen stated, “My impression is that markets are well functioning, trading volumes are robust, and traders are not having problems executing trades.” The ability of the Treasury market to absorb shocks and disturbances, as opposed to amplifying them, will be improved by the reforms being implemented, she said.
While the Treasury has been seeking input on a proposal to buy back illiquid bonds, the Securities and Exchange Commission has proposed two ambitious plans to increase market resiliency.
Investors believe that the Fed may ultimately pause its current attempts to sell down some of the securities on its balance sheet or even restart its quantitative easing programme if the situation demands. The Fed has intervened to stabilize markets during prior crises, such as in March 2020.
But considering that everyone, from pension funds to foreign governments, places their money in the market for security, making it the world’s de facto borrowing benchmark, the perception of fragility surrounding the US Treasury market is a topic of vital worry for investors.
Any persistent issues or a price decline would have worldwide repercussions on stocks, corporate bonds, and currencies.
According to Yesha Yadav, a professor at Vanderbilt Law School who studies Treasury market regulation, “It’s not only the fact of having poor liquidity… it’s also what that suggests for financial regulation, which is solely dependent on the ability to sell Treasuries.” “If you are unable to guarantee that because liquidity is not operating as it should, I believe that does say something, not only about the stability of the Treasury market but also about the stability of the financial markets as a whole.”
Liquidity and volatility
Investors agree that, regardless of the workings of the market, the liquidity in the Treasury bond market was always going to worsen this year.
As the Fed has aggressively tightened monetary policy, Treasury yields, which move alongside interest rates, have been significantly more volatile than typical. It was inevitable that trading would become more difficult and costly in such an unstable environment. Furthermore, data from Sifma, the trade association for the securities sector, shows that even though the cost and complexity of dealing with Treasuries have increased, trading volumes have held stable until 2022.
“It makes sense that transaction costs would increase as volatility increased. According to Isaac Chang, head of global fixed income trading at Citadel, “Volatility has increased dramatically as we’ve seen the Fed raise rates in 75 basis point increments at an unprecedented pace. Liquidity issues must be viewed in that context.
Market liquidity typically decreases as volatility rises. However, according to some knowledgeable observers of US Treasuries, the causal link has shifted in the opposite direction, where illiquidity is now driving part of the volatility.
Up until August of this year, Brian Sack, the director of economics at the hedge fund DE Shaw, served as vice-chair of the Treasury Borrowing Advisory Committee. The committee released a report about market liquidity issues in May and advised the Treasury on how much and what it should borrow.
According to Sack, “for much of the year, we’ve seen concerns about the functioning of the Treasury market, but for a time, this looked to be primarily driven by the volatility of rates emerging from fundamental factors.”
But in recent months, the state of the Treasury market’s liquidity has gotten worse. This most recent development is more worrisome since it appears that market functioning now poses a greater risk to investors rather than merely reflecting the unsteady fundamental environment.
The majority of observers believe that the liquidity issues in the Treasury market are caused by more than simply quickly fluctuating prices; they also reflect a lack of buyers, as well as their inability or unwillingness to absorb all of the available supply.
According to Major of HSBC, the Treasury department’s discussion of the possibility of repurchasing some of the least liquid Treasury bonds is a tacit admission that waning demand is starting to present issues.
The recent expansion of the Treasury market and the retreat of the largest buyers of that debt, most notably the Fed and the Bank of Japan, are two factors that have led to fresh worries regarding demand. As part of its quantitative tightening campaign, the Fed has started stepping back from the Treasury market. Additionally, in order to maintain the yen against the strong dollar, the Bank of Japan has been selling part of its foreign bond holdings, which are believed to be mostly Treasury bonds and are driven by the policies of the Ministry of Finance.
The Treasury market might develop further as a result of higher rates. The president of the trading platform MarketAxess, Chris Concannon, predicts that the overall Treasury market will expand significantly in order to pay the interest rates. “You’re going to see a considerable increase just to support the payments needed to pay the rates,” the speaker said.
Regulations put in place in the wake of the financial crisis have made holding Treasury bonds by primary dealers, the banks that purchase bonds directly from the Treasury and have historically been a source of liquidity, more expensive. This has contributed to the withdrawal of major buyers from the Treasury market.
High-speed traders and hedge funds have stepped in to fill the void left by primary dealers’ reduced involvement in supplying liquidity. These investors have acted differently than primary dealers because they are less regulated. Market observers claim that there have been significant periods of market volatility when high-speed traders have refrained from supplying liquidity.
High-speed traders’ and hedge funds’ engagement has increased market leverage, which contributed to the market crisis in March 2020. Hedge funds in the basis trade, leveraged wagers that aimed to take advantage of minute discrepancies in bond prices, were forced to unwind their positions as panicky investors sold Treasuries, hastening the sell-off.
It is challenging to determine if there are now any comparable pools of leverage in Treasury securities. Treasury trading is unregulated, and positioning data is difficult to find, particularly for non-bank participants. The information that is accessible, like that highlighted in the Fed’s financial stability report, is only released after a wait of many months.
The most recent study noted that hedge fund leverage measures are higher than normal. Insufficient data “raises the potential that such enterprises are employing leveraged positions, which might amplify unfavorable shocks, especially if they are supported with short-term funds,” the paper stated.
Regulators get more serious
Regulators have been anxious to stress that the market has not been affected in the midst of this worry.
There have been no indications of huge leveraged positions being forcibly sold off despite this year’s extreme volatility and low liquidity. Even though Treasury market data is notoriously opaque, the market is receiving so much attention that any symptoms of trouble could be detected rather fast.
In addition to the debate about potential buybacks of unmarketable bonds, at least one Fed governor has suggested the prospect of relaxing some of the capital requirements for large banks, which would allow their balance sheets to keep additional Treasury securities.
There have also been suggestions made to enhance how the market operates. The SEC’s plans could, in fact, represent the largest overhaul to US market regulation since the 2010 Dodd-Frank act.
The two major ideas would govern non-bank participants in the Treasury market similarly to how banks are regulated. The first, known as the “dealer rule,” would make it necessary for anyone who transacts on the Treasury market for more than $25 billion per month to register as a dealer, requiring them to disclose more information about their trading and positions and raising the amount of capital they need to do so.
In accordance with the second proposal, more trades would have to be centrally cleared, increasing the number of Treasury market transactions that would require a third party to guarantee the transaction and raising the minimum cash reserves required by participants.
In a report from October, the International Financial Stability Board, which advises the G20 countries on financial rules, suggested that raising the capital requirement for non-bank liquidity providers and encouraging central clearing could help to stabilize core markets like Treasury securities in times of low liquidity.
The dealer rule has drawn more criticism than the SEC’s central clearing proposal. Particularly hedge funds have said that the regulations are so broad-reaching that they will harm both funds that make speculative trades and funds that regularly trade in the Treasury market to control their risk. The increased capital requirements would also fundamentally alter the industry because hedge funds often have thin balance sheets and borrow money to place wagers.
Due to the size of these changes, several hedge funds have threatened to completely exit the market, which would worsen the market’s liquidity issues. According to Bryan Corbett, CEO of Managed Funds Association, “The SEC’s dealer rule imposes an unrealistic regulatory structure that would compel many funds to limit or terminate their Treasury trading activities.” The proposal will have the opposite effect of the SEC’s stated goal, increasing concentration, decreasing market participation, and volatility.
If this causes these investors to participate less in the Treasury market, new buyers for US government debt will need to be identified, particularly once the regulations take effect in the next years. Still it will not happen immediately, the year 2023 is not going to be dramatically different.
A new set of holders will need to be found, and perhaps some of those turns out to be weak hands, says Brad Setser, a fellow at the Council on Foreign Relations and a former Treasury official under President Obama. “It is possible that the real risk will only come after a year of QT [quantitative tightening] and a year of increased private absorption of Treasuries,” he adds.
As in the UK, where the Bank of England temporarily suspended its quantitative tightening programme to support the market, a significant Treasury market crisis would likely result in a Fed intervention.
But a market where the Fed is frequently obliged to interfere also doesn’t convey the kind of assurance and stability that investors throughout the world rely on.
Setser asserts that because the Treasury market is so much more significant on a worldwide scale, “if there were to be the kind of disruption we’ve seen in the gilts market in the Treasury market, there would be a wider global impact.”