Tensions in $23 Trillion US Government Debt Market Intensify as Fed Tightens Monetary Policy

Investors’ ability to trade US government debt has deteriorated to its lowest point since the March 2020 riots, raising concerns about the world’s most important bond market as the Federal Reserve tightens monetary policy.

Liquidity, or the ease of buying and selling, in US government securities has declined since the beginning of this year, reaching levels not seen since the first months of the coronavirus crisis, according to an index compiled by Bloomberg.

Deteriorating trading conditions have exacerbated this month’s price fluctuations, with investors increasingly concerned about how well the market will perform as the Federal Reserve begins to downsize its $9 trillion balance sheet.

Treasuries are already on track to post their worst quarter since at least 1973 after the Federal Reserve raised interest rates for the first time. since 2018 this month in its attempt to combat inflation, which is at its highest level in 40 years. It has also halted its crisis-era bond-buying program.

At the same time, the war in Ukraine has caused several volatility shocks in Treasuries in recent weeks. Such intense volatility is unusual and worrying in the $23 trillion market, widely considered the deepest in global finance, traders and investors say.

Bloomberg US Government Securities Liquidity Index line chart showing Treasury market liquidity has worsened

“The challenges related to liquidity and market function took a back seat when the Federal Reserve 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 starting to shrink again, we are seeing the return of concerns about the role of the market.”

The Treasury market forms the bedrock of international finance, so price movements spill over into other markets, affecting everything from mortgage rates to stock prices. The severe global market turmoil at the start of the pandemic in March 2020 was significantly worsened by strong price movements in US government bonds.

Treasuries typically rally in times of growing market jitters as traders hoard their cash in safer assets, but prices fell in 2020 as a jolt of risk aversion sent participants running out of debt. of the US government. The Federal Reserve was forced to intervene to stabilize the market by committing to purchase unlimited amounts of government bonds and taking steps to boost the corporate debt market for the first time in history.

Column chart of Bloomberg US Treasury Aggregate Index Quarterly Total Returns (%) showing US bonds in historical sell-off

Now that the Fed is pulling back on stimulus measures it launched deep into the pandemic, investors are concerned that long-term problems with the functioning of the Treasury market could leave it vulnerable again.

Primary dealers, the 24 financial institutions that are the traditional market makers in Treasuries, have stepped out of 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 withdraw from markets during periods of turmoil, a factor some analysts say increases volatility.

new rules proposed on monday by the Securities and Exchange Commission will begin the process of fixing some of these structural problems, but progress has been, and is expected to continue to be, slow.

Big price moves in recent days that have occurred without an apparent trigger present a warning of things to come, according to Mark Cabana, head of US rates strategy at Bank of America. “When I see moves like that happening for no good reason, against a backdrop of an already fragile Treasury market functioning, and even before [the Fed starts selling bonds] – I just worry about it,” he said.

Cabana added that increased volatility could tighten financial conditions, making it harder for businesses and consumers to obtain financing, which “could slow the economy down quite significantly.”

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