U.S. government bond scholars are starting to worry about how the world’s largest market will fare when the Federal Reserve withdraws its support in the era of the pandemic.
The $ 22 billion treasury bill market forms the basis for pricing other assets around the world. It is famous for its liquidity – a broad term meaning that it is easy to enter and exit transactions. But on several occasions since the first hit of Covid-19, liquidity gaps have arisen, creating jerky price movements.
When the Fed begins to cut its bond buying program by $ 120 billion per month, perhaps as early as November, some participants worry that the lack of once-reliable market support may no longer generate instability.
The Treasury market system “is designed for high-frequency traders and primary traders to step back when problems arise,” said Yesha Yadav, a professor at Vanderbilt Law School in Nashville who studies market structure and regulation. of the Treasury.
“The way this is set up is designed to fail. He is exceptionally fragile, ”Yadav said.
The Treasury bill market collapsed during the Covid shock of 2020. Perhaps this was the inevitable result of investors rushing globally to reshape portfolios. But central banks and regulators were also alarmed when at one point Treasury prices fell rapidly – the opposite of typical patterns in times of stress – because liquidity evaporated. More recently, in February, low participation in a standard seven-year debt auction caused prices to drop significantly.
“For people with March 2020 and February 2021 in mind, it reminds people that there are risks to the functioning of the Treasury market as we see the Fed trying to pull out of the market,” said Mark Cabana, responsible for US interest rate strategy. at the Bank of America.
A key responsibility here lies with the primary dealers, the 24 financial companies responsible for providing a flow of buying and selling prices for Treasury bills by the Fed. They include banks such as JPMorgan Chase, Citigroup, and Goldman Sachs. Data from the Financial Industry Regulatory Authority suggests they pulled out in February and March of last year before the Fed stepped in to stabilize the market.
Primary traders deal directly with the Treasury Department, and they theoretically help support the market as buyers when other investors try to sell. But Dodd-Frank regulations in the aftermath of the 2008 financial crisis forced banks to hold more capital on their balance sheets to offset the debt they owned. In response, the primary dealers reduced the amount of their debt relative to the size of the Treasury market.
“The banks were never there to catch the falling knife, but they certainly acted as a pretty huge liquidity buffer for the market in a way that they can’t or don’t want today,” said Kevin McPartland, Head of Marketplace Structure and Technology. research at the Greenwich Coalition.
The Securities Industry and Financial Markets Association, an industry lobbying firm representing large lenders, wrote earlier this year that changing bank balance sheet rules would make the market work.
“A slight easing of the balance sheets of the primary dealers would probably help reduce these more frequent bouts of volatility, and we would still have a much more secure system” than before the financial crisis, said Tyler Wellensiek, global head of market structure. rate at Barclays.
But maintaining the rules brings benefits: Capital requirements on banks likely averted major crises in the industry during the coronavirus recession, according to the Bank for International Settlements. And changing capital requirements would potentially put the United States in violation of the post-2008 Basel international accord, said Greg Peters, co-chief investment officer of PGIM Fixed Income.
As primary dealers have stepped back from their role as market makers, hedge funds and high frequency traders, notably Citadel Securities, Virtu Financial and Jump Trading, have taken their places. But when the markets become volatile, high frequency trading funds can also retreat.
Data from the Greenwich Coalition shows that order book volume – much of which is made up of high-frequency trader activity – has declined during recent liquidity issues. In March of last year, the average daily order book volume on a relative basis to other execution methods fell to its lowest level since 2014 and has not fully recovered since.
Regulators have discussed making changes to strengthen the liquidity of the Treasury market. But progress on all of these reforms has been slow, and the lack of a centralized treasury market regulator can be confusing.
Yet not everyone expects a crisis.
“It was telegraphed very well by the Fed,” said Jan Nevruzi, strategist at NatWest Markets. This communication is likely to avoid a tantrum like the one observed in 2013.
The Fed’s reverse repo program – which allows banks to put liquidity into the US central bank overnight in exchange for Treasuries – can stabilize liquidity in a crisis, said Ellis Phifer, strategist market at the financial consulting firm Raymond James.
But the reverse repo facility is a safety net, said Edward Al-Hussainy, analyst at Columbia Threadneedle Investments, and not a permanent solution to how the market works.
“It’s not a market that’s ready for the kind of environment we find ourselves in, where shocks are common,” Al-Hussainy said. “We are seeing events that are supposed to be rare happening with disturbing frequency.”
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