Traders are worried about the world’s largest and most important government bond market, as the Federal Reserve quickens the pace at which it removes one of its primary pandemic supports.
When the global economy crashed in March 2020 and markets went into free fall, the U.S. Treasury market — the $25 trillion bedrock of the global financial system — broke down. Sellers struggled to find buyers, and prices whipsawed higher and lower. The Fed stepped in, devoting trillions of dollars to steadying the market.
The importance of the Treasury market is hard to overstate. It is the main source of funding for the U.S. government and underpins borrowing costs around the globe, for a huge variety of assets. If you have a mortgage, the interest rate you received was probably priced in relation to Treasuries. The same goes for credit cards, business loans and just about anything with an interest rate attached to it. The proper functioning of this market is paramount.
That’s why even small wobbles in this market can generate huge worries. At its worst, a Treasury trading breakdown could cause the value of the dollar, stocks and other bonds to tumble. Economies that borrow a lot in dollars and hold Treasuries in their reserves would teeter. Crucially, the U.S. government could find it hard to finance itself, even up to defaulting 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, an interest rate strategist at Bank of America, wrote in a research report last week. He sees emerging strains in the Treasury market as “the single greatest 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 huge quantities, in a move known as quantitative easing, or Q.E. By becoming the buyer of last resort, the Fed helped restore confidence in markets, and trading in Treasuries began to recover.
The Fed’s balance sheet ballooned from a little over $4 trillion in early 2020 to a peak of nearly $9 trillion two years later. Stability also brought investment back to the stock market, enriching investors and helping stoke inflation.
Now, the Fed is reversing course through quantitative tightening, or Q.T., pulling back its support for financial markets while it raises interest rates to quell inflation. Some investors worry that the quickening pace of the Fed’s pullback could become too much for markets to bear, 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 market watchers are most worried about as the Fed’s balance sheet shrinks is something called liquidity — trader jargon for 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, Treasuries — at a stable price with little trouble. Illiquidity, on the other hand, is like a blocked water pipe; it’s hard to push anything through, and what does get past the blockage comes in spurts, with prices moving sharply higher or lower as trades fail to be fulfilled in a predictable way.
Since June 2021, the Fed has been letting a small number of bonds mature without being replaced. Starting this month, the Fed will allow up to $60 billion of Treasuries and $35 billion of mortgage bonds to roll off its balance sheet as the debts come due, twice as much as the past three months.
As the Fed backs away, it’s not clear who will fill the void. And even if new buyers for bonds can be found, the reduction in demand caused by the Fed’s exit is raising fears among traders of volatility that could make future market disturbances worse.
Measures of price volatility are already elevated, and liquidity is the worst it has been since the pandemic-induced sell-off in early 2020, said Subadra Rajappa, an interest rate strategist at Société Générale. “The Fed doesn’t want to find itself in that situation again,” she said. Last week, some traders pointed to the ramping up of Q.T., combined with comments by Fed officials about rate increases, to explain large swings in Treasury prices.
Previous attempts by the Fed to shrink its balance sheet did not go entirely smoothly. In September 2019, the Fed was about a year into the unwinding of the bond-buying program that stemmed from the 2008 financial crisis. Even though it was shrinking its balance sheet at roughly half the pace it is proposing now, a dearth of cash in the system roiled markets. The Fed had to step in and buy Treasuries to help the market function again.
Today, the Fed’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 sure they are that the price won’t move significantly shortly after the trade is complete. With so much uncertainty — over the health of the economy, the course of the Russian-Ukrainian war or the path of inflation, to name just a few things — it’s harder to price trades, reducing liquidity.
The sheer scale of U.S. government debt also plays an important role. The Treasury market has doubled over the past decade, to around $25 trillion, as the government’s financing needs have grown. All that debt needs to be bought by someone, and not just the Fed.
If demand for Treasuries can’t keep pace with the supply, it could pull 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 grappling with the Fed’s campaign to lower inflation by raising interest rates.
“I am worried that we are piling Q.T. on top of these rate hikes and it will push us into recession,” said George Catrambone, the head of Americas trading and chief operating officer at DWS group.
Others say lessons learned from past shocks make the risks less daunting. The Fed has introduced a permanent facility that could supply emergency cash to market participants in case of a liquidity crunch. A group of U.S. financial regulators is also looking at other ways to bolster the Treasury market.
Importantly, the Fed is not actively selling its holdings; it’s just not reinvesting them as they come due. And investors won’t necessarily have to buy everything the Fed is letting run off its balance sheet. In fact, the Treasury has significantly reduced its borrowing over the past year as the financing needs of the government during the pandemic have declined. In turn, this has reduced the number of Treasuries that need to be bought by investors.
Brian Sack, a managing director of the D. E. Shaw Group and a former New York Fed official, said he did not expect the Fed’s shrinking balance sheet to worsen conditions in the Treasury market. “There are not any compelling signs that they won’t be able to continue Q.T. for a while,” he said.
Still, in a May report the Fed noted a worsening of liquidity and said that “the risk of a sudden significant deterioration appears higher than normal.” That is what’s unsettling traders as the Fed unwinds its pandemic support program with untested speed.
“By itself you could argue it’s not a big deal,” said Priya Misra, an interest rate strategist at TD Securities. “But viewed in the context of a less liquid environment where stress events are having a bigger impact, that is why I am nervous about Q.T. ramping up.”
Jeanna Smialek contributed reporting.
