Traders worry about the world’s largest and most important government bond market as the Federal Reserve picks up the pace of removing one of its key pandemic supports.
When the global economy collapsed in March 2020 and markets plunged, the US Treasury market, the $25 trillion base of the global financial system, collapsed. Sellers struggled to find buyers, and prices went up and down. The Federal Reserve has stepped in and injected trillions of dollars to stabilize the market.
The importance of the US Treasury market cannot be overemphasized. It is the primary source of funding for the U.S. government and underpins the cost of borrowing worldwide for a huge variety of assets. If you have a mortgage, the interest you receive is probably set in relation to government bonds. The same goes for credit cards, business loans, and anything with interest. The proper functioning of this market is paramount.
So even a small wobble in this market can raise big concerns. In the worst case, a US Treasury trading crash could cause the value of the dollar, stocks and other bonds to plummet. An economy that borrows heavily in dollars and holds government bonds as reserves will wobble. Significantly, the U.S. government may find it difficult to raise funds until it defaults.
“This sounds like a bad sci-fi movie, but unfortunately it’s a real threat,” Bank of America rates strategist Ralph Axel wrote in a research report last week. He sees the new tensions in the Treasury market as “today’s biggest systemic financial risk,” potentially more damaging than the housing market turmoil that preceded the 2008 financial crisis. increase.
In response to market turmoil in the early stages of the 2020 coronavirus pandemic, the Fed unleashed its firepower to buy large amounts of mortgage and government bonds in a move known as quantitative easing or QE. did. As a last resort, the Fed helped restore market confidence and Treasury trading began to recover.
The Fed’s balance sheet has ballooned from just over $4 trillion in early 2020 to nearly $9 trillion two years later. Stabilization also brought back investment in the stock market, enriching investors and fueling inflation.
Now the Fed is reversing course through Quantitative Tightening (QT), raising interest rates to keep inflation in check while reducing support for financial markets. Some investors fear that the pace of Fed cuts could become unbearable and undermine the safety and credibility of the US Treasury market.
“Ultimately, any bond off the Fed’s balance sheet will disrupt the market,” said Curvature Securities trader Scott Skyme.
As the Fed’s balance sheet shrinks, the number one concern for market watchers is something called liquidity. It is a trader’s jargon for the ease of buying and selling a financial asset.
When a market is liquid, money flows freely and easily, and investors can buy and sell financial assets (in this case, US Treasuries) at stable prices with little difficulty. On the other hand, illiquidity is like a clogged water pipe. It’s hard to push anything through, and deals don’t execute in a predictable way, causing prices to rise or fall sharply, proliferating over the blockage.
Since June 2021, the Fed has matured a small number of bonds without reissuing them. Starting this month, the Fed will allow up to $60 billion in Treasury bills and his $35 billion mortgage bonds to roll off the balance sheet at twice his debt maturities in the past three months.
It’s not clear who will fill the void as the Fed retreats. And even if new buyers are found for bonds, the reduced demand from the Fed’s exit has raised volatility concerns among traders and could exacerbate future market turmoil.
Societe Generale rates strategist Subhadra Rajappa said price volatility had already increased and liquidity was at its worst since the pandemic-induced plunge in early 2020. “The Federal Reserve does not want to be in that situation again,” she said. Last week, some traders pointed to the rise in QT, coupled with her Fed official’s comments on rate hikes, to explain the large swings in Treasury prices.
The Fed’s previous attempts to shrink its balance sheet have not been entirely smooth sailing. In September 2019, the Fed came almost a year after unwinding the bond-buying program that sparked his 2008 financial crisis. A cash shortage in the system has roiled the market, even as it has been shrinking its balance sheet at about half the pace currently proposed. The Federal Reserve had to step in and buy government bonds to help the market work again.
The Fed’s shrinking balance sheet isn’t the only reason liquidity is currently low. The price at which a buyer or seller wishes to transact depends on their confidence that the price will not fluctuate significantly immediately after the transaction is completed. So much uncertainty over the health of the economy, the course of the Russian-Ukrainian war, and the course of inflation will make trading difficult to price and less liquid.
The size of the US government’s debt also plays an important role. The treasury market has doubled over the past decade to about $25 trillion as the government’s demand for funds grows. All that debt needs to be bought by someone, not just the Fed.
If demand for government bonds can’t keep up with supply, prices may fall. Prices move inversely to bond yields, a measure of borrowing costs. A rise in Treasury yields would put more pressure on borrowers already engaged in the Federal Reserve’s campaign to raise interest rates and reduce inflation.
“I’m worried that these rate hikes, plus the QT stack, could drive the economy into a recession,” said George Cattranborn, Americas trading officer and chief operating officer at DWS Group.
Others say the lessons learned from past shocks reduce risk. The Fed has introduced a permanent facility that can provide emergency cash to market participants in the event of a liquidity squeeze. A group of US financial regulators are also considering other ways to strengthen the US Treasury market.
Importantly, the Fed is not actively selling its holdings. It’s just not reinvesting when it’s due. Also, investors don’t necessarily have to buy everything the Fed is draining off its balance sheet. In fact, the Treasury has slashed its borrowings over the past year as the government’s funding needs have declined during the pandemic. This has reduced the number of government bonds that investors need to buy.
Brian Sack, managing director of DE Shaw Group and former New York Fed staffer, said he doesn’t expect the Fed’s shrinking balance sheet to worsen conditions in the Treasury market. “There’s no compelling indication that he can’t continue QT for a while,” he said.
yet, in the May report Federal Reserve notes liquidity deterioration, saying “the risk of a sudden and significant deterioration looks higher than usual”. It’s this that worries traders as they scale back the program.
“You could argue that it’s not a big deal on its own,” said Priya Misra, rates strategist at TD Securities. “But in the context of a less liquid environment, where stress events have a greater impact, that’s why I’m nervous about raising QT.”
Gianna Smirek contributed to the report.