The cracks in the US Treasury bond market

Buying and selling in the world’s biggest bond market is supposed to be easy. However, for most of this year, says Gregory Whiteley, a bond portfolio manager at DoubleLine Capital, it has been anything but straightforward.

Whiteley says a trader used to be able to get hold of $400mn of US Treasury bonds — not an outsize quantity in this $24tn market — as a routine matter. But now that typically involves breaking up the order into smaller chunks; perhaps doing $100mn of the trade electronically, he explains, and then picking up the phone to see if they can prise the rest of the debt from the hands of Wall Street’s trading desks over the course of a day.

The US Treasury bond market suffered a huge scare at the start of the coronavirus pandemic when fears about a collapse in the global economy led to a sudden slump in prices and liquidity.

Now as the Federal Reserve battles to rein in inflation, a recession looms and most asset prices have faced a dramatic sell-off, the world’s most important bond market is creaking once again.

Liquidity in the market — one crucial measure of how well it is functioning — is at its worst levels since March 2020 after a dramatic decline in the past year. Market depth, a measure of liquidity which refers to the ability of a trader to buy or sell Treasuries without moving prices, is also at its worst level since March 2020, according to Jay Barry at JPMorgan.

“Markets are in a much more fragile place, with terrible liquidity,” says Greg Peters, co-chief investment officer at PGIM Fixed Income. “The way I think about fragile market function is that the odds of a financial accident are just higher.”

All this was happening even before the recent meltdown in UK government debt, which has added to the anxiety about the vulnerability of the world’s large bond markets.

While investors are not concerned about an exact replay of the UK crisis, in which pension funds placed leveraged bets on the direction of bonds at a large scale, many fear that an unforeseen wave of selling could quickly overwhelm the US bond market’s shaky infrastructure.

“The wobble in the gilts market was a fire drill for everyone else,” says Steven Major, global head of fixed income research at HSBC. In some cases, investors say, a lack of liquidity is driving volatility in US bond prices, rather than the other way round.

Regulators have unveiled a slew of measures aimed at improving the functioning of the market. At an important annual conference on Wednesday hosted by the New York Fed, officials will discuss with industry leaders ongoing efforts to improve the market’s resilience.

“My assessment is that markets are well functioning, trading volumes are large, traders are not having difficulty executing trades,” Janet Yellen, the US Treasury secretary, said at the end of October in a speech on the subject. Reforms were being developed to “improve the Treasury market’s ability to absorb shocks and disruptions, rather than to amplify them”, she said.

The Securities and Exchange Commission has put forward two ambitious proposals to improve the market’s resilience, while the Treasury has been consulting on a proposal to buy back illiquid bonds.

The Fed has stepped in to stabilise markets during previous crises, such as in March 2020, and ultimately it could suspend its ongoing efforts to sell down some of the securities on its balance sheet or even restart its quantitative easing programme if the situation demanded, investors believe.

But the sense of vulnerability around the US Treasury market is a matter of vital concern for investors given that everyone, from pension funds to foreign governments, puts their money in the market for safekeeping, making it the world’s de facto borrowing benchmark.

Any sustained problems or a collapse in prices would have global consequences, ricocheting through stocks, corporate bonds and currencies.

“It’s not simply the fact of having shit liquidity?.?.?.?it’s also what that implies for financial regulation, which is singularly premised on Treasuries being able to be sold easily,” says Yesha Yadav, a professor at Vanderbilt Law School who researches Treasury market regulation. “If you can’t guarantee that because liquidity is not working as it should be, I think that does imply something, not just about Treasury market stability, but about broader financial market stability.”

Volatility and liquidity

Investors acknowledge that liquidity in the Treasury bond market was bound to deteriorate this year, regardless of the mechanics of the market.

Treasury yields, which move with interest rates, have been much more volatile than usual as the Fed has aggressively tightened monetary policy. Amid so much uncertainty, it was inevitable that it would be harder and more expensive to trade. And while the cost and difficulty with which investors trade in Treasuries has risen, trading volumes have remained steady through 2022, according to data from Sifma, the securities industry’s trade group.

“As volatility goes up, it is only natural for the cost of transactions to go up. Volatility has gone up significantly, as we’ve seen the Fed hike rates in 75 basis point increments at an unprecedented pace,” says Isaac Chang, head of global fixed income trading at Citadel. “Liquidity concerns need to be viewed in that context.”

Increased volatility tends to lead to reduced liquidity in the market. However, for some seasoned observers of US Treasuries, the causal relationship has begun to swing in the opposite direction, where illiquidity is now driving some of the volatility.

Brian Sack, the director of economics at hedge fund D.E. Shaw, was the vice-chair of the Treasury Borrowing Advisory Committee until August of this year. The committee makes recommendations to the Treasury about how much and what it should borrow, and in May delivered a report about liquidity issues in the market.

“For much of the year there we’ve seen concerns about Treasury market functioning, but for a time this appeared mostly driven by the volatility of yields arising from fundamental developments,” says Sack.

“In recent months, however, liquidity in the Treasury market has deteriorated further. This recent development is more concerning, as it seems as if market functioning has become a bigger source of risk, rather than just reflecting the uncertain fundamental environment.”

For most analysts, the liquidity problems in the Treasury market are not just about rapidly changing prices, they are also a reflection of a dearth of buyers, or an inability or unwillingness of the buyers in the market to mop up all the supply.

The fact the Treasury department has begun discussing the prospect of buying back some of the most illiquid Treasury bonds, says HSBC’s Major, is an implicit acknowledgment that faltering demand has begun to cause problems.

One reason for the new questions about demand has been that the Treasury market has ballooned in size in recent years and the biggest buyers of that debt, most notably the Fed and the Bank of Japan, are stepping back. The Fed has been pulling back from the Treasury market as part of its quantitative tightening programme. And the Bank of Japan — guided by the policies of the Ministry of Finance — has been selling some of its foreign bond holdings, thought to consist largely of Treasuries, to support the yen against the strong dollar.

Higher rates could cause the Treasury market to expand further. “The overall Treasury market is going to grow dramatically in order to pay the interest rates,” says Chris Concannon, president of trading platform MarketAxess. “To pay the rates, you’re going to see sizeable growth just to fund the payments required.”

The retreat of major buyers in the Treasury market has also been a function of regulations introduced following the financial crisis that have made it more expensive for primary dealers — the banks that buy bonds directly from the Treasury, and have been a traditional provider of liquidity — to hold Treasuries.

As primary dealers have limited their role, high-speed traders and hedge funds have taken their place to provide much-needed liquidity. These investors are less regulated and have behaved differently from how primary dealers did. Market watchers say there have been important moments of instability in the market where high-speed traders have pulled back from providing liquidity.

The involvement of hedge funds and high-speed traders has also injected more leverage into the market — a factor that exacerbated the market crisis in March 2020. As panicked investors were selling Treasuries, hedge funds in leveraged bets known as the basis trade that sought to exploit small anomalies in bond prices were forced to unwind their positions, accelerating the sell-off.

Whether there are similar pools of leverage in Treasuries at present is hard to assess. Trading in Treasuries is opaque, and information about positioning, especially among non-banks, is hard to come by. The data that is available — such as that cited in the Fed’s financial stability report — is only published with a delay of several months.

The latest report notes that measures of hedge fund leverage are above historical averages. “These gaps [in receiving the data] raise the risk that such firms are using leveraged positions, which could amplify adverse shocks, especially if they are financed with short-term funding,” the report said.

The regulators get serious

Amid such concern, regulators have been eager to point out that the market has not been disrupted.

In spite of the high volatility and poor liquidity this year, there have been no signs of forced selling of major leveraged positions. The enormous attention focused on the market also means that any signs of problems could be picked up fairly quickly, even if transparency in Treasury market data is notoriously poor.

In addition to the discussion about possible buybacks of illiquid bonds, at least one Fed governor has mentioned the possibility of easing some of the capital requirements on big banks, which would free their balance sheets to hold more Treasuries.

There have also been proposals trying to improve the functioning of the market. Indeed, the proposals put forward by the SEC could represent the biggest changes in US market regulation since the 2010 Dodd-Frank act.

The two main proposals would regulate non-bank players in the Treasury market in similar ways to banks. The first, known as the dealer rule, would require any Treasury market participant trading more than $25bn a month to register as a dealer, forcing them to be more transparent about their trading and positions and increasing their capital requirements.

The second proposal would require more trades to be centrally cleared, meaning more deals in the Treasury market would have to be guaranteed by a third party, and the participants in the deal would have to have more cash on hand to place the bets.

The international Financial Stability Board, which makes recommendations to the G20 nations on financial rules, said in a report from October that increasing the capital cushion required of non-bank liquidity providers and encouraging central clearing could help to stabilise core markets such as Treasuries in moments of poor liquidity.

The SEC’s central clearing proposal has not provoked much backlash, but the dealer rule has. Hedge funds in particular have said that the rules are so sweeping they would affect funds that trade in the Treasury market on a regular basis to manage their risk, in addition to those placing speculative trades. What’s more, hedge funds typically have small balance sheets and borrow to make bets, and the new capital requirements would fundamentally change the business model of these firms.

These changes are so significant that some hedge funds have threatened to pull out of the market entirely, which would exacerbate the liquidity problems the market is facing.

“The SEC’s dealer rule imposes an unworkable regulatory structure that would cause many funds to reduce or cease their Treasury trading activity,” says Bryan Corbett, chief executive of Managed Funds Association. “The rule will lead to greater concentration, fewer market participants, and increased volatility, which is the opposite of the SEC’s stated objective.”

If that leads to reduced participation by these investors in the Treasury market, then new buyers for US government debt will need to be found, especially after the rules come into effect in the coming years.

“It is possible that the real risk will only come after a year of QT [quantitative tightening] and a year of increased private absorption of Treasuries because a new set of holders will have to be found, and maybe some of those turn out to be weak hands,” says Brad Setser, a fellow at the Council on Foreign Relations and a former Treasury official under President Obama.

Ultimately, a large-scale Treasury market crisis would likely lead to an intervention by the Fed — just as in the UK, the Bank of England temporarily halted its quantitative tightening programme to backstop the market.

However, a market in which the Fed is regularly forced to intervene is also not one that communicates the kind of stability and security that investors around the world depend on.

“If there were to be the kind of disruption that we’ve seen in the gilts market in the Treasury market, there would be a bigger global impact just because the Treasury market is so much more important globally,” says Setser.