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Specialists Warn That The Withdrawal Of Pandemic-Era Support Will Lead To Instability In The Treasury Market

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EDITOR'S NOTE: Insider Voice reports that “the $ 22 trillion Treasury market forms the basis for pricing other assets around the world,” and now experts are worried that the Fed easing out of propping this market up, which it has been doing throughout the pandemic, could have catastrophic implications. Vanderbilt Law School Yesha Yadav, says for the bond market, “The way it is configured is designed to fail. It is exceptionally fragile.” While the pandemic had a huge impact on the world economy, central banks untangling themselves from their stimulus packages during that time could be even worse. 

US government bond specialists are beginning to worry about how the world’s largest market will fare when the Federal Reserve withdraws its pandemic-era support.

The $ 22 trillion Treasury market forms the basis for pricing other assets around the world. It is famous for its liquidity, a broad term that means it is easy to get in and out of trades. But on several occasions since the first Covid-19 hit, liquidity gaps have appeared, creating sharp price movements.

When the Fed begins cutting its $ 120 billion-a-month bond-buying scheme, possibly in November, some participants fear that the lack of once-reliable market support could lead to further instability.

The Treasury market system “is primed for high-frequency traders and primary traders to back off when there are problems,” said Yesha Yadav, a professor at Vanderbilt Law School in Nashville who studies the structure and regulation of the Treasury market. .

“The way it is configured is designed to fail. It is exceptionally fragile, ”Yadav said.


The Treasury market turned upside down in the 2020 Covid impact. That was perhaps the inevitable result of investors globally rushing to reshape portfolios. But central banks and regulators were also alarmed when at one point Treasury prices fell rapidly, the opposite of typical stressful patterns, because liquidity evaporated. More recently, in February, the weak acceptance of a seven-year standard debt auction caused a significant decline in the price.

“For people who have March 2020 and February 2021 fresh on their minds, this reminds them that there are risks to the functioning of the Treasury market, as we see the Fed trying to withdraw from the market,” said Mark Cabana, chief. of US Rate Strategy at Bank of America.

Some key responsibility here rests with the so-called primary distributors, the 24 financial firms tasked with providing a flow of Treasury buy and sell prices from the Fed. They include banks like JPMorgan Chase, Citigroup and Goldman Sachs. Data from the Financial Industry Regulatory Authority suggest they fell back in February and March last year before the Fed intervened to stabilize the market.

Primary distributors transact directly with the treasury department and theoretically help support the market as buyers when other investors try to sell. But the Dodd-Frank regulation in the wake of the 2008 financial crisis forced banks to keep more capital on their balance sheets to offset the debt they held. In response, primary dealers have reduced the amount of debt they have relative to the size of the Treasury market.

“The banks were never there to catch the falling knife, but they certainly acted as a great liquidity buffer for the market in a way that they can’t or don’t want to today,” said Kevin McPartland, head of market structure and technology. research at Coalition Greenwich.

The Securities Industry and Financial Markets Association, an industry lobbying firm representing large lenders, wrote earlier this year that changing the bank’s balance sheet rules would guarantee a smooth operation of the market.

“A modest easing of primary dealers’ balance sheets would likely help reduce these more frequent bouts of volatility, and we would still have a much safer system” than before the financial crisis, said Tyler Wellensiek, global head of rate market structure. from Barclays.

But sticking with the rules brings benefits: Capital requirements imposed on banks have likely prevented major crises in the sector 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 international Basel accord, said Greg Peters, co-chief investment officer at PGIM Fixed Income.

As primary traders have moved away from their market-making role, hedge funds and high-frequency traders, including Citadel Securities, Virtu Financial, and Jump Trading, have moved into place. But when markets become volatile, HF trading funds can also pull out.

Data from Coalition Greenwich shows that the volume of the order book, a large part of which is made up of the activity of high-frequency traders, has declined during recent liquidity shortages. In March last year, average daily order book volume on a relative basis compared to other execution methods fell to the lowest level since 2014 and has not fully recovered since.

Regulators have discussed the possibility of making changes to strengthen the liquidity of the Treasury bond market. But progress on all these reforms has been slow, and the lack of a centralized Treasury market regulator can cause confusion.

However, not everyone expects a crisis.

“This has been very well telegraphed by the Fed,” said Jan Nevruzi, strategist at NatWest Markets. That communication is likely to prevent a tantrum like the one seen in 2013.

The Fed’s reverse buyback program, which allows banks to deposit cash with the U.S. central bank overnight in exchange for Treasuries, can stabilize liquidity in the event of a crisis, said Ellis Phifer, strategist market analysis of the financial advisory firm Raymond James.

But the reverse buyback facility is an endorsement, said Edward Al-Hussainy, an analyst at Columbia Threadneedle Investments, and not a permanent solution to how the market works.

“This is not a market that is prepared for the kind of environment we find ourselves in, where crashes are frequent,” Al-Hussainy said. “We are seeing events that are supposed to be rare occurring with disturbing frequency.”

Originally posted on Insider Voice


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