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The next financial crisis may already be underway, but not where many expect




A growing number of traders, academics and bond market gurus are concerned that the $24 trillion market for US government debt could be heading for a crisis as the Federal Reserve kicks its “quantitative tightening” into high gear this month.

As the Fed doubles the pace at which its bond holdings will “roll off” its balance sheet in September, some bankers and institutional traders worry that already thinning liquidity in the Treasury market could set the stage for financial disaster — or, short of that, bring a host of other downsides.

In the corners of Wall Street, some have pointed to these risks. A particularly stark warning came earlier this month, when Bank of America BAC,
-0.39%
Fixed income strategist Ralph Axle warned the bank̵[ads1]7;s clients that “decline in liquidity and robustness in the treasury market is undoubtedly one of the biggest threats to global financial stability today, potentially worse than the housing bubble of 2004-2007”.

How could the normally stable financial market become ground zero for a new financial crisis? Well, Treasuries play a critical role in the international financial system, with their yields benchmarking trillions of dollars of borrowing, including most mortgages.

Around the world, the 10-year government yield TMUBMUSD10Y,
3.416%
is considered the “risk-free rate” that sets the baseline against which many other assets – including stocks – are evaluated.

But outsized and erratic movements in Treasury yields are not the only problem: since the bonds themselves are used as collateral for banks seeking short-term funding in the “repo market” (often described as the “beating heart” of the US financial system) it is possible that if if the financial market recovers — as it almost has recently — various credit channels including corporate, household and government loans would “cease,” Axle wrote.

See: Stock market wildcards: What investors need to know as Fed shrinks balance sheet at faster pace

Aside from an all-out blowout, thinning liquidity comes with a host of other downsides for investors, market participants and the federal government, including higher borrowing costs, increased volatility across assets and — in a particularly extreme example — the possibility that the Fed could default on its debt if auctions of newly issued government bonds cease to function properly.

Shrinking liquidity has been a problem since before the Fed began shrinking its massive balance sheet of nearly $9 trillion in June. But this month, the pace of that easing will accelerate to $95 billion a month — an unprecedented pace, according to a pair of Kansas City Fed economists who published a paper on those risks earlier this year.

Uncredited

According to Kansas City Fed economists Rajdeep Sengupta and Lee Smith, other market participants that might otherwise help offset a less active Fed are already at, or close to, capacity in terms of their Treasury holdings.

Uncredited

This could further exacerbate thinning liquidity, unless another class of buyers arrives – making the current period of Fed tightening potentially far more chaotic than the previous episode, which took place between 2017 and 2019.

“This QT [quantitative tightening] the episode could play out quite differently, and maybe it won’t be as calm and quiet as the last episode started,” Smith said during a phone interview with MarketWatch.

“Since banks’ balance sheet space is lower than it was in 2017, it is more likely that other market players will have to step in,” Sengupta said on the call.

At some point, higher yields should attract new buyers, Sengupta and Smith said. But it’s hard to say how high yields will have to go before that happens – although it looks like the market is about to find out as the Fed pulls back.

“Liquidity is quite poor right now”

To be sure, financial market liquidity has been thinning for some time now, with a number of factors at play, even as the Fed continues to scoop up billions of dollars of government debt per month, something it only stopped doing in March.

Since then, bond traders have noticed unusually wild swings in what is usually a more stable market.

In July, a team of fixed income strategists at Barclays BARC,
-1.19%
discussed symptoms of Treasury market thinning in a report prepared for the bank’s clients.

These include wider bid-ask spreads. The spread is the amount that brokers and dealers charge to facilitate a trade. According to economists and academics, narrower spreads are usually associated with more liquid markets, and vice versa.

But widening spreads are not the only symptom: Trading volume has fallen significantly since the middle of last year, the Barclays team said, as speculators and traders increasingly turn to financial markets to take short-term positions. According to Barclays’ data, the average aggregate nominal trading volume for Treasuries has fallen from nearly $3.5 trillion every four weeks at the start of 2022 to just over $2 trillion.

At the same time, market depth – that is, the dollar amount of bonds offered through dealers and brokers – has worsened significantly since the middle of last year. The Barclays team illustrated this trend with a chart, which is included below.

Source: Barclays

Other measures of bond market liquidity confirm the trend. For example, the ICE Bank of America Merrill Lynch MOVE Index, a popular gauge of implied volatility in the bond market, was above 120 on Wednesday, a level that indicates options traders are preparing for more moves ahead in the Treasury market. The gauge is similar to the CBOE Volatility Index, or “VIX,” Wall Street’s “fear gauge” that measures expected stock market volatility.

The MOVE index reached almost 160 back in June, which is not far from the 160.3 peak from 2020 seen on March 9 of the same year, which was the highest level since the financial crisis.

Bloomberg also maintains a liquidity index in US government securities with a maturity of more than one year. The index is higher when treasuries trade further away from “real value”, which usually happens when liquidity conditions deteriorate.

It was at about 2.7 on Wednesday, right around the highest level in more than a decade, excluding spring 2020.

Thinning liquidity has had the biggest impact along the short end of the Treasury curve — since short-dated Treasuries are typically more vulnerable to Fed rate hikes, as well as changes in the outlook for inflation.

In addition, Treasurys, a term used to describe all but the most recent issuances of government bonds for each maturity, have been affected more than their “on the run” counterparts.

Because of this thinning liquidity, traders and portfolio managers told MarketWatch that they need to be more careful about the size and timing of their trades as market conditions become increasingly volatile.

“Liquidity is pretty tight right now,” said John Luke Tyner, a portfolio manager at Aptus Capital Advisors.

“We’ve had four or five days in the last few months where the two-year Treasury has moved more than 20 [basis points] on a day. It’s absolutely eye-opening.”

Tyner previously worked on the institutional fixed income desk at Duncan-Williams Inc. and has been analyzing and trading fixed income products since shortly after graduating from the University of Memphis.

The importance of being fluent

Treasury debt is considered a global reserve asset – just as the US dollar is considered a reserve currency. This means that it is widespread by foreign central banks that need access to dollars to facilitate international trade.

To ensure that Treasurys retain this status, market participants must be able to trade them quickly, easily and cheaply, Fed economist Michael Fleming wrote in a 2001 paper titled “Measuring Treasury Market Liquidity.”

Fleming, who still works at the Fed, did not respond to a request for comment. But interest rate strategists at JP Morgan Chase & Co. JPM,
-0.52%,
Credit Suisse CS
+0.47%
and TD Securities told MarketWatch that maintaining good liquidity is just as important today — if not more so.

The reserve status of Treasurys provides countless benefits to the US government, including the ability to finance large deficits relatively cheaply.

What can be done?

When chaos overturned global markets in the spring of 2020, the financial market was not spared the fallout.

As the Group of 30’s Working Group on Treasury Market Liquidity recounted in a report recommending tactics to improve the functioning of the Treasury market, the fallout came surprisingly close to causing global credit markets to seize up.

As brokers pulled liquidity for fear of being saddled with losses, the financial market saw big moves that seemingly made little sense. Interest rates on government bonds with similar maturities were completely unhinged.

Between March 9 and March 18, bid-ask spreads exploded and the number of “trade failures” – which occur when a book trade fails to settle because one of the two counterparties does not have the money or assets – rose to about three times the normal rate.

The Federal Reserve eventually came to the rescue, but market participants had been alerted, and the Group of 30 decided to explore how a repeat of these market disruptions could be avoided.

The panel, which was chaired by former Treasury Secretary and New York Fed President Timothy Geithner, published its report last year, which included a number of recommendations to make financial markets more resilient in times of stress. A group of 30 representatives were unable to make any of the authors available for comment when contacted by MarketWatch.

The recommendations included establishing universal clearing of all treasury trades and repos, establishing regulatory deviations from regulatory leverage ratios to allow dealers to store more bonds on their books, and establishing standing repo operations at the Federal Reserve.

While most of the report’s recommendations have yet to be implemented, the Fed established standing repo facilities for domestic and foreign dealers in July 2021. And the Securities and Exchange Commission is taking steps toward mandating more centralized clearing.

However, in a status update released earlier this year, the task force said Fed easing did not go far enough.

On Wednesday, the Securities and Exchange Commission is preparing to announce that it will propose rules to help reform how Treasuries are traded and cleared, including ensuring that more Treasury trades are centrally cleared, as the group of 30 recommended, as MarketWatch reported.

See: SEC to advance reforms to avert next crisis in $24 trillion market for U.S. government debt

As the Group of 30 noted, SEC Chairman Gary Gensler has expressed support for expanding centralized clearing of government bonds, which would help improve liquidity in times of stress by helping to ensure that all trades are settled on time without any hiccups.

Still, if regulators seem complacent about addressing these risks, it’s likely because they expect that if something goes wrong, the Fed can simply ride to the rescue, as it has done in the past.

But Bank of America’s Axel believes this assumption is wrong.

“It is not structurally sound for the US public debt to become increasingly dependent on Fed QE. The Fed is a lender of last resort to the banking system, not to the federal government,” Axel wrote.

– Vivien Lou Chen contributed reporting



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