Is the world's safest market becoming hard to trade?

On 12 October Janet Yellen said the US Treasury was worried about a loss of adequate liquidity in the government bond market. When the issuer of the world's leading risk-free asset frets in public about whether it can be traded, investors should listen. Her remark was more than polite regulatory concern. It amounted to an admission that the market's design has failed. The $24 trillion Treasury market underpins asset pricing and collateralised lending around the world, and it is showing signs of chronic strain in its plumbing. Bid-ask spreads on off-the-run maturities have widened to levels seldom seen outside acute crises, and market depth, the volume of orders standing just behind the best price, has fallen by more than two-thirds.

The odd thing is that there has been no credit event. The US government is in no danger of missing a coupon. The market is choking on the volume of paper passing through dealers whose balance sheets are, in effect, frozen by regulation. The primary dealers, who underwrite Treasury auctions and are meant to quote prices both ways at all times, work under capital rules drawn up in the banking reforms after 2008. The supply of government debt has outgrown the private capacity to trade it.

Three warnings in eight years

Officials have seen this coming for some time. On 15 October 2014 the ten-year yield lurched down and back up within minutes on no news, an episode that prompted a joint report from the regulators and the first serious look at who actually provides liquidity. The answer was uncomfortable: in the electronic interdealer market for newly issued bonds, high-speed principal trading firms had largely displaced the banks, and those firms hold almost no inventory overnight.

The second warning came in March 2020, when foreign central banks, hedge funds and mutual funds all tried to sell Treasuries for cash at the same moment. Dealers could not absorb the flow, prices of the safest bonds on earth gapped lower, and the Federal Reserve had to buy government debt on a scale without modern precedent to restore order. The third warning is this autumn's slow grind, which is less dramatic but more persistent, because it has arrived without any single panic to explain it.

Capital rules pinch dealers

The bottleneck runs through the supplementary leverage ratio (SLR). Under post-crisis rules, the biggest global banks must hold capital against every asset on their balance sheets, whatever its credit risk. A Treasury note or an overnight reverse repo attracts the same leverage charge as a leveraged loan or a junk bond. During the pandemic the Federal Reserve temporarily excluded Treasuries and bank reserves from the SLR to keep markets working, but it let that relief lapse in March 2021.

Since then the stock of marketable Treasury debt has kept growing, driven by persistent federal deficits, while the balance-sheet capacity of primary dealers has barely changed. When bond volatility rises, as it has throughout 2022 amid the fastest monetary tightening in forty years, value-at-risk limits force bank trading desks to cut inventory. Dealers refuse to hold off-the-run bonds, so ordinary bouts of selling turn into sharp price gaps that spread into interest-rate swaps and mortgage-backed securities.

The central bank itself has stepped back as a buyer. Quantitative tightening began in June, and since September the Fed has let up to $60bn of Treasuries a month mature without replacement. Every bond it declines to roll over has to find a private home, and the private homes with the most flexible balance sheets are exactly the dealers that the leverage ratio constrains.

Who pays for thin markets

The cost of poor liquidity is spread widely and rarely itemised. Asset managers pay it in wider spreads every time they rebalance. Pension funds and insurers pay it when hedges they assumed could be adjusted cheaply turn out to be expensive to move. Mortgage borrowers pay it indirectly, because the spread between mortgage-backed securities and Treasuries widens when dealers will not warehouse either.

The ultimate payer is the taxpayer. Investors who expect to struggle when they need to sell demand a higher yield when they buy, and that liquidity premium is built into every auction the Treasury holds. With deficits large and the Fed no longer a buyer, a few basis points of extra premium on trillions of dollars of issuance becomes a real line in the federal budget.

A warning from London

Britain has just shown what happens when a sovereign bond market loses its footing. After the government's fiscal statement on 23 September, gilt yields jumped so fast that pension funds using liability-driven investment strategies faced collateral calls they could meet only by selling gilts, which pushed yields higher still. The Bank of England had to launch emergency purchases of long-dated gilts on 28 September, and within a month the prime minister had resigned.

The gilt market is smaller and its crisis had a specific fiscal trigger, so the parallel is imperfect. The mechanism, however, is general: when forced sellers meet dealers without room on their balance sheets, the central bank becomes the only buyer left. American officials watching London had every reason to ask how much spare capacity their own market has.

Buybacks as a release valve

The Treasury is now considering something it has not done in the modern era: regular buybacks of its own debt, paid for by issuing new bills. By retiring older, illiquid off-the-run bonds and replacing them with highly liquid short-term bills, the government would become its own dealer of last resort. Holders stuck with off-the-run paper would have a guaranteed buyer, the yield curve would be smoother and private investors might demand less of a premium for volatility. The last time Washington bought back its own bonds was around the turn of the century, and then the aim was to retire debt with budget surpluses, not to keep a market functioning.

A standing buyback programme brings problems of its own. Buying back hundreds of billions of long-dated bonds means flooding the short end with bills just as the Federal Reserve is trying to shrink its balance sheet through quantitative tightening. And if the Treasury takes duration risk off private hands to keep trading going, the line between managing the national debt and conducting monetary policy starts to blur.

Other fixes are on the table. In September the Securities and Exchange Commission proposed that more cash and repo trades in Treasuries be settled through a central clearing house, which would let dealers net offsetting positions and free balance-sheet space. The Fed's standing repo facility, set up in July 2021, already offers dealers cash against Treasury collateral. Neither measure adds a dealer, and the clearing proposal will take years to implement.

What would settle it

The case against alarm is that the market still clears every day, auctions are covered and the Fed has shown it will step in during a genuine panic. That is true, and it is also the problem: a market that works only with a central-bank backstop has handed its liquidity risk to the public sector. The Treasury's quarterly refunding announcement in early November, and any detail it gives on buybacks, will show how seriously officials take the diagnosis.

Fragile Treasury plumbing has become the main constraint on quantitative tightening around the world. Until regulators exempt Treasuries from the leverage ratio or the Treasury starts buying back its own bonds, the next sell-off will probably find dealers unable to take the other side. Until bank capital rules are adjusted permanently to fit the size of the federal debt, the liquidity of the world's safest market will remain an unhedged risk for the whole financial system, and the first test will come the next time volatility forces leveraged holders to sell into a market with nobody standing behind the bid.