Unraveling the recent turmoil in the US Treasury market
The US Treasury market, the largest and most liquid government bond market in the world, has experienced its steepest bout of volatility since the global financial crisis in 2008-2009. The trigger for the market’s convulsions was the sudden collapse of Silicon Valley Bank (SVB), a small lender that held billions of dollars in deposits, including from many hedge funds and institutional investors that needed to meet margin calls and other obligations.
The news of SVB’s insolvency, which became public on March 8, 2021, triggered a rush into safety assets, with the virtual flight-to-quality pushing up the prices of US Treasury bonds and depressing their yields. The Treasury market also saw a surge in trading activity, with daily volumes more than doubling to nearly $1.5 trillion, according to the TRACE system that tracks securities transactions. The frenzy of buying and selling caused the yields on some maturities to swing wildly in both directions, hitting their highest levels in over a year before plunging to record lows.
Despite the sharp increase in volatility, the Treasury market managed to function relatively smoothly during the crisis, without any major disruptions or failures. This is a notable achievement, given the crucial role that the Treasury market plays in the global financial system, as a benchmark for interest rates, a source of financing for the US government, and a haven asset for investors in times of stress.
However, the recent episode also revealed some weaknesses and challenges facing the Treasury market, which could amplify its vulnerability to sudden shocks and limit its capacity to absorb shocks without spillover effects. One key issue is the decline in liquidity, or the ease of buying and selling Treasury bonds without affecting their prices or the stability of the market. While the overall volume of trading in Treasury bonds has risen over the past decade, the concentration of ownership has become more dispersed, with fewer primary dealers and more non-bank counterparties, such as hedge funds, trading platforms, and proprietary trading firms.
This fragmentation of the market has reduced the ability of primary dealers to act as liquidity providers of last resort, by absorbing excess supply or demand of Treasury bonds when other market participants withdraw or become inactive. The primary dealers, who are designated by the Federal Reserve Bank of New York, have also faced higher capital and operational costs, as well as regulatory restrictions on their activities and balance sheets, since the financial crisis. Moreover, the business models of some primary dealers have shifted away from market making and inventory holding, towards electronic trading, algorithmic strategies, and risk management services.
As a result, the Treasury market may be more susceptible to sudden bursts of volatility, liquidity gaps, and dislocations, especially if shocks coincide with flight-to-quality episodes, margin calls, or force majeure events. This could lead to asymmetric pricing, contagion risks, higher borrowing costs for issuers and borrowers, and impaired transmission of monetary policy actions. For example, the recent spike in yields on 10-year Treasury notes, which rose from 1.4% to nearly 1.6% in a matter of days, could reflect a realignment of market expectations about inflation, growth, and fiscal stimulus, or it could be a sign of strained liquidity and fragmented trading.
To mitigate these risks and enhance the resilience of the Treasury market, several proposals have been put forward by policymakers, regulators, and market participants. These include:
– Strengthening the role of primary dealers as market makers and lenders of last resort, by providing them with more flexible access to the Fed’s discount window and liquidity facilities, reducing their regulatory burden, and enhancing their incentives to maintain stable market conditions.
– Encouraging greater participation of other financial institutions in the Treasury market, such as pension funds, insurance companies, and endowments, which could provide a more stable and diversified investor base, with longer holding horizons and less reliance on leverage.
– Improving the transparency, accessibility, and standardization of the Treasury market, by enhancing the reporting requirements, data quality, and operational resilience of trading platforms, auction processes, and post-trade infrastructures, potentially leveraging new technologies such as distributed ledgers and smart contracts.
– Coordinating more closely with other central banks and regulators, both domestically and internationally, to align policies, reduce spillovers, and enhance crisis management capabilities, through bilateral swap agreements, open market operations, and cross-border surveillance and resolution frameworks.
These and other measures may help to address some of the structural and cyclical challenges facing the Treasury market, and to promote a more stable, efficient, and inclusive financial system. However, they also entail costs, trade-offs, and uncertainties, and require careful balancing of economic, social, and political considerations. The recent volatility in the Treasury market should serve as a wake-up call for policymakers and investors alike, to better understand and manage the risks and opportunities of this critical market, and to ensure that it remains resilient and adaptive in the face of future challenges.#Treasuries #rollercoaster #ride #strains #bond #market #functioning