The U.S. Treasury bond market has tumbled this year. That’s no surprise.
Between the Federal Reserve’s interest rate hikes and quantitative tightening, 10-year Treasury yields have increased from 1.6 percent to more than 4.0 percent year to date. (Bond yields have an inverse relationship with bond prices.)
But this doesn’t feel like a regular bond bear market. While the bond market appears calm on the surface, increasingly, there’s talk of a “liquidity crisis” brewing from too many forces acting in unison. In other words, a functioning market—no matter which direction it’s going—needs both active buyers and sellers. Today’s market has been whipsawing, with extremely low liquidity (meaning very, very few buyers at any price) and high volatility. And that could be bad news not just for the Treasury bond market, but for other financial markets.
Earlier this month, Treasury Secretary Janet Yellen expressed concern that she was “worried about a loss of adequate liquidity.” On Oct. 20, Yellen’s staff even asked the Treasury Bond Auction Committee (a consortium of investment banks that run bond auctions) if the U.S. Treasury should begin buying some less-liquid bonds to provide liquidity. That’s an unusual and concerning request.
The ICE BofAML MOVE Index, the de facto measure of bond market volatility, is at its highest since the middle of 2009—the thick of the last financial crisis. Yields on both two- and five-year bonds are at multi-decade highs.
Let’s quickly examine what has been happening. Liquidity has been declining ever since the Fed began raising interest rates. The Fed’s ending quantitative easing—buying of bonds—and starting of quantitative tightening has worsened liquidity by taking out one of the market’s biggest purchasers of bonds. More interest rate hikes are expected to come.
The U.S. dollar will continue to strengthen as the Fed increases rates to battle inflation. That will cause other countries to intervene and defend their currencies. To do so, they will need to sell U.S. Treasury bonds, adding more downward pressure to bond prices.
In a vacuum, these moves all make sense individually. But all of these selling activities converging at once could likely seize up the bond market. Remember: A sale can only occur between two willing parties. It’s unclear who will do the buying.
The Financial Times also points out a little-known market structure problem that has yet to be tested.
“Previously, the primary dealers (i.e., big banks) kept the treasuries market liquid in a crisis by acting as market makers. But after 2008, a string of regulatory reforms made it expensive to play this role,” the financial paper noted in an Oct. 20 report. “As a result, primary dealers’ transactions are now just 2 percent of the market, down from 14 percent in 2008.”
In a note to clients, Bank of America analysts said that bond market liquidity is “fragile and vulnerable to shock.”
There are a lot of risks facing the markets today. Persistent inflation, continued interest rate hikes, the U.S. and global economy, geopolitical challenges in Europe (Russia–Ukraine) and East Asia (China), and their effects on businesses, employment, and ultimately, the financial markets.
The surging dollar is also threatening a traditional source of demand for U.S.-denominated assets. Sovereign wealth funds and foreign pension funds have historically been big buyers of U.S. assets, both equities and bonds. But the bear market in both of these asset classes, coupled with a very strong dollar, has dampened foreign demand. Foreign countries now need to sell U.S. dollar-denominated assets to defend their currencies. This is another under-the-radar source of liquidity drying up.
At almost $24 trillion, the U.S. Treasury bond market is huge. But if this market seizes up and freezes, the consequences could be wide ranging and hard to prepare for.
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