The world’s most important market needs some fixing
The world’s most important market is broken. Rather than the measured temperature-takers of the economy, U.S. Treasury securities are acting like panic-stricken children who claim to have heard something go bump in the night.
The yield on the benchmark two-year note has been swinging wildly, spanning an average of about half-a-percentage point between the highs and lows each day last week. A move of a couple of basis points is usually considered a lot for the security. Implied volatility as measured by the ICE Bofa MOVE Index surged to the highest since late 2008, during the apex of the global financial crisis. Bloomberg News reported on Friday that veteran macro trader Adam Levinson is shutting down his hedge fund, the first high-profile casualty of the violent moves in fixed-income markets.
Sure, there was a lot for bond investors and traders to digest, namely bank runs at a few midsized American lenders that led to a government takeover and a bailout; as well as a crisis at Switzerland’s Credit Suisse Group AG that ended in a forced union with rival UBS Group AG over the weekend.
Oh, and there’s still the issue of stubbornly high inflation, and whether the Federal Reserve ignores the rising odds of a recession and adds gas to the bank fire with another interest rate increase this week.
But it’s hard not to conclude that the gyrations in the bond market contributed heavily to the unease permeating all financial markets. After all, the Treasury market is the market that all others take their cue from — equities, credit, currencies, etc. It may seem odd, given the central role Treasuries play in the global financial system, that behind the massive fluctuations in the bond market is a lack of liquidity, which exacerbates moves in prices and yields.
The spread between offered prices and what sellers will accept has widened for all maturities in the $24 trillion market for cash Treasuries, Bloomberg News reported, a sign of thinning market depth. “Liquidity is significantly compromised,” Jpmorgan Chase & Co. strategists Jay Barry and Jason Hunter wrote in a research note Tuesday.
That’s an understatement. A Bloomberg index shows trading liquidity for Treasuries has gotten five times worse since 2021 and, outside of a short spike in the early days of the pandemic, is worse than at anytime since the financial crisis.
The Fed can help. While the monetary policy debate is focused on whether the Fed should raise rates by another quarter of a percentage point or do nothing when policymakers announce their decision Wednesday, perhaps it would be best if they choose to slow or even pause the quantitative tightening program. Whereas quantitative easing, or QE, injects liquidity into the financial system through bond purchases,
QT has the opposite effect.
Wouldn’t slowing or pausing QT run counter to the Fed’s efforts to contain inflation? Not likely. Just like there’s no strong evidence that many years of QE had the desired effect of sparking inflation, it’s unlikely that QT is helping to temper inflation. An abrupt pause in rate hikes would likely resurrect the notion that there’s, indeed, a Fed “put” designed to bail out Wall Street at the first sign of stress.
Liquidity has been diminishing for years, mainly due to the Fed’s QE program. It took a massive amount of bonds out of the financial system, expanding the Fed’s balance sheet assets from less than $1 trillion in 2007 to $9 trillion in 2022. As a result, volatility collapsed. The amount of Treasuries traded among primary dealers has changed little since 2009 despite the amount of marketable debt outstanding having grown from about $4.5 trillion to $24 trillion.
Volatility, though, is the lifeblood of traders. So, what happened along the way is that experienced bond traders who knew how to navigate turbulent markets left the business as their paychecks sank. Those famous bond desks that once drew Wall Street’s best and brightest, as described by Tom Wolfe in “Bonfire of the Vanities” and Michael Lewis in “Liar’s Poker” were no longer attractive. What you’re left with are relative newcomers who only know a market marked by relative calm and controlled by the Fed, zero interest rates and QE.
Yes, the Fed has a lot on its plate now, but the liquidity crisis in the bond market is a critical issue that can’t be put off, or worse, ignored. Make no mistake, if the Treasury market seizes up, the global economy and financial system will have much bigger problems than some bank runs.