Traders are concerned about the world’s largest and most important government bond market as the Federal Reserve picks up the pace at which it removes one of its main pandemic props.
When the global economy crashed in March 2020 and markets went into free fall, the US Treasury market, the $25 trillion foundation of the global financial system, collapsed. Sellers struggled to find buyers, and prices rose and fell. The Federal Reserve stepped in, devoting trillions of dollars to stabilize the market.
It’s hard to overstate the importance of the Treasury market. It is the main source of financing for the US government and supports borrowing costs around the world, for a wide variety of assets. If you have a mortgage, the interest rate you received was probably set relative to Treasury bills. The same goes for credit cards, business loans, and just about anything with an interest rate attached. The proper functioning of this market is paramount.
This is why even small swings in this market can lead to big concerns. In the worst case, a collapse in Treasury operations could cause the value of the dollar, stocks and other bonds to plummet. Economies that borrow heavily in dollars and hold Treasuries in their reserves would stumble. Crucially, the US government could struggle to finance itself, even to default on its debt, the financial equivalent of an earthquake.
“While this sounds like a bad science fiction movie, it is unfortunately a real threat,” Ralph Axel, interest rate strategist at Bank of America, wrote in a research report last week. He sees the emerging tensions in the Treasury market as “the biggest systemic financial risk today,” with the potential to do more damage than the housing turmoil that preceded the 2008 financial crisis.
In response to market turmoil in the early stages of the coronavirus pandemic in 2020, the Fed unleashed the full force of its firepower, buying mortgage bonds and government debt in large quantities, in a move known as quantitative easing, or QE. By becoming the buyer. As a last resort, the Fed helped restore confidence in the markets and Treasury bond trading began to recover.
The Fed’s balance sheet soared from just over $4 trillion in early 2020 to a high of nearly $9 trillion two years later. The stability also brought investment back into the stock market, making investors richer and helping to spur inflation.
Now the Fed is changing course through quantitative tightening, or QT, withdrawing its support from financial markets while raising interest rates to stifle inflation. Some investors worry that the fast pace of the Fed’s withdrawal could be 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 are going to disrupt the market,” said Scott Skyrm, a trader at Curvature Securities.
What most concerns market watchers as the Fed’s balance sheet shrinks is something called liquidity: traders’ jargon refers to the ease of buying and selling a financial asset.
When markets are liquid, money flows freely and easily, and investors can buy and sell a financial asset, in this case Treasury bonds, at a stable price with no problems. Lack of liquidity, on the other hand, is like a blocked water pipe; it’s hard to get anything moving forward, and what it does get past the lockdown comes in spurts, with prices rising or falling sharply as trades don’t take place in a predictable manner.
Since June 2021, the Fed has been letting a small number of bonds expire without being replaced. Starting this month, the Fed will allow up to $60 billion in Treasuries and $35 billion in mortgage bonds to be wiped off its balance sheet as debts come due, twice as many as in the last three months.
As the Fed backtracks, it’s unclear who will fill the void. And even if new bond buyers can be found, the reduced demand caused by the Fed’s departure is raising fears among traders about volatility that could worsen future market shocks.
Measures of price volatility are already elevated, and liquidity is the worst since the pandemic-induced sell-off in early 2020, said Subadra Rajappa, interest rate strategist at Société Générale. “The Fed doesn’t want to find itself in that situation again,” he said. Last week, some traders pointed to QT’s gradual rise, combined with comments from Fed officials about rate hikes, to explain the large swings in Treasury prices.
Previous attempts by the Fed to reduce its balance sheet have not been entirely easy. As of September 2019, the Federal Reserve was about a year into unwinding the bond-buying program that grew out of the 2008 financial crisis. Even though it was shrinking its balance sheet at about half the pace it is now proposing, the shortage of cash in the system affected the markets. The Fed had to step in and buy Treasuries to help get the market moving again.
Today, the Federal Reserve’s shrinking balance sheet is not the only reason liquidity is deteriorating. The price that buyers or sellers are willing to trade for depends on how confident they are that the price will not move significantly soon after the transaction is complete. With so much uncertainty (about the health of the economy, the course of the Russo-Ukrainian war, or the path of inflation, to name just a few things), it is harder to price trades, reducing liquidity.
The magnitude of US government debt also plays a role. The Treasury market has doubled over the past decade, to around $25 trillion, as the government’s funding needs have grown. All of that debt needs to be bought by someone, and not just the Federal Reserve.
If demand for Treasuries can’t keep up with supply, it could push prices down. Prices move in the opposite direction to bond yields, a measure of borrowing costs. Higher Treasury yields would put more pressure on borrowers already dealing with the Fed’s campaign to reduce inflation by raising interest rates.
“I am concerned that we are piling QT on top of these rate hikes and pushing us into recession,” said George Catrambone, head of trading and director of Americas operations at DWS group.
Others say that lessons learned from past crises make the risks less daunting. The Fed has introduced a permanent facility that could provide emergency cash to market participants in the event of a liquidity crisis. A group of US financial regulators is also looking at other ways to boost the Treasury market.
Importantly, the Fed is not actively selling its holdings; it is simply not to reinvest them as they come due. And investors won’t necessarily have to buy everything the Fed is letting off its balance sheet. In fact, the Treasury has significantly reduced its borrowing over the past year as the government’s financing needs have diminished during the pandemic. In turn, this has reduced the amount of Treasury bonds that investors must buy.
Brian Sack, managing director of DE Shaw Group and a former New York Fed official, said he did not expect the Fed’s balance sheet reduction to worsen conditions in the Treasury market. “There are no convincing signs that they won’t be able to continue CT for a while,” he said.
Calm, in a May report The Fed noted worsening liquidity, saying “the risk of a sudden significant deterioration appears higher than normal.” That is what is making traders uneasy as the Fed rolls back its pandemic support program with untested speed.
“On its own, you could argue it’s not a big deal,” said Priya Misra, interest rate strategist at TD Securities. “But seen in the context of a less liquid environment where stress events have a greater impact, that’s why I’m nervous about increasing QT.”
Joanna Smialek contributed report.