Traders are concerned about the world’s largest and most important government bond market as the Federal Reserve accelerates the pace at which it lifts one of its key pandemic support measures.
When the global economy crashed and markets went into freefall in March 2020, the US treasury market — the $25 trillion foundation of the global financial system — collapsed. Sellers struggled to find buyers, and prices kept getting higher and lower. The Fed stepped in and spent trillions of dollars stabilizing the market.
The importance of the Treasury market is hard to overestimate. It is the primary source of funding for the US government and supports borrowing costs around the world, across a wide variety of assets. If you have a mortgage, the interest you received was probably priced relative to government bonds. The same goes for credit cards, business loans, and just about anything that has an interest rate attached to it. The proper functioning of this market is paramount.
Therefore, even small swings in this market can be a major concern. At worst, a breakdown of Treasury trading could cause the value of the dollar, stocks and other bonds to plummet. Economies that borrow heavily in dollars and keep Treasury bills in their reserves would falter. Crucially, the US government could find it difficult to fund itself, even to the point of defaulting on its debt, the financial equivalent of an earthquake.
“While this sounds like a bad science fiction movie, unfortunately it is a real threat,” Ralph Axel, an interest rate strategist at Bank of America, wrote in a investigative report last week. He views emerging tensions in the Treasury market as “the greatest systemic financial risk today”, with the potential to do more damage than the housing turmoil that preceded the 2008 financial crisis.
In response to the market turmoil in the early stages of the coronavirus pandemic in 2020, the Fed unleashed the full force of its firepower by buying up mortgage bonds and sovereign debt in huge quantities, in a move known as quantitative easing, or QE. . as a last resort, the Fed helped restore confidence in the markets and Treasury trading began to recover.
The Fed’s balance sheet rose from just over $4 trillion in early 2020 to peak at nearly $9 trillion two years later. Stability also returned investment to the stock market, enriching investors and helping to push inflation up.
Now the Fed is reversing its course through quantitative tightening, or QT, and withdrawing its support from the financial markets, while raising interest rates to suppress inflation. Some investors worry that the accelerated pace of the Fed’s pullback could become too much for the markets, undermining the safety and reliability of the treasury market.
“Eventually, all those bonds coming off the Fed’s balance sheet will disrupt the market,” said Scott Skyrm, a trader at Curvature Securities.
What market watchers are most concerned about as the Fed’s balance sheet shrinks is something called liquidity — trading jargon for the convenience of buying and selling financial assets.
When markets are liquid, money flows freely and easily, and investors can buy and sell financial assets — in this case, government bonds — at a stable price with little effort. Illiquidity, on the other hand, is like a clogged water pipe; it’s hard to push anything through, and what gets past the blockage comes in spurts, with prices going sharply higher or lower as trades aren’t executed in a predictable way.
Since June 2021, the Fed has let a small number of bonds mature without being replaced. Starting this month, the Fed will roll up to $60 billion in government bonds and $35 billion in mortgage bonds from its balance sheet when debt falls due, twice as much as it has in the past three months.
As the Fed pulls out, it’s not clear who will fill the void. And even if new bond buyers can be found, the reduced demand following the Fed’s departure is fueling fears among traders of volatility that could exacerbate future market disruptions.
Measures of price volatility are already high and liquidity is the worst since the pandemic-induced sell-off in early 2020, said Subadra Rajappa, an interest rate strategist at Société Générale. “The Fed doesn’t want to get into that situation again,” she said. Last week, some traders pointed to the increase in QT, coupled with comments from Fed officials about rate hikes, to explain wide swings in Treasury bill prices.
Previous attempts by the Fed to reduce its balance sheet have not been entirely smooth. In September 2019, the Fed had spent about a year unwinding the bond-buying program that resulted from the 2008 financial crisis. While it was shrinking its balance sheet at about half the rate it’s now projecting, a lack was swirling. of cash in the system markets. The Fed had to step in and buy Treasury bills to get the market functioning again.
Today, the Fed’s shrinking balance sheet is not the only reason liquidity is deteriorating. The price at which buyers or sellers are willing to trade depends on how confident they are that the price will not rise significantly shortly after the trade is completed. With so much uncertainty – about the health of the economy, the course of the Russo-Ukrainian war or the path of inflation, to name a few – it is more difficult to price transactions, reducing liquidity.
The sheer size of the US government debt also plays an important role. The Treasury market has doubled to about $25 trillion in the past decade as government financing needs have increased. All that debt has to be bought by someone, not just the Fed.
If the demand for Treasuries cannot keep up with the supply, it can drive prices down. Prices move in the opposite direction to bond yields, a measure of borrowing costs. Higher government bond yields would put more pressure on borrowers already struggling with the Fed’s campaign to lower inflation by raising interest rates.
“I’m concerned that we’re piling QT on top of these rate hikes and it’s going to push us into a recession,” said George Catrambone, head of US commerce and chief operating officer at the DWS group.
Others say the lessons learned from past shocks mitigate the risks. The Fed has introduced a standing facility that can provide market participants with emergency money in the event of a liquidity crisis. A group of US financial regulators is also looking at other ways to strengthen the treasury market.
Importantly, the Fed is not actively selling its holdings; it’s just not about reinvesting them when they expire. And investors don’t necessarily have to buy everything the Fed drains off its balance sheet. In fact, the Treasury has significantly reduced its borrowing over the past year as government borrowing needs have declined during the pandemic. This in turn has reduced the number of Treasuries to be bought by investors.
Brian Sack, a director of the DE Shaw Group and a former New York Fed official, said he did not expect the Fed’s shrinking balance sheet to worsen conditions in the Treasury market. “There are no compelling signs that they can’t continue QT for a while,” he said.
Still, in a report from May the Fed noted a deterioration in liquidity, saying that “the risk of a sudden significant deterioration appears greater than normal.” That is what worries traders as the Fed unwinds its pandemic support program at an unprecedented pace.
“In itself, you could say it’s not a bad thing,” said Priya Misra, interest rate strategist at TD Securities. “But seen in the context of a less fluid environment where stress events have a greater impact, that’s why I’m nervous about increasing QT.”
Jeanna Smialek reporting contributed.