The rate hike the Fed can't avoid

The benchmark 10-year US Treasury yield rose to 4.954 per cent on 11 September after a very weak Treasury debt buyback showed that liquidity in the bond market is thinning as inflation refuses to fade. The Federal Reserve now has little choice but to raise rates.

Dealers stop taking paper

The Treasury runs regular buybacks to improve liquidity in older, off-the-run issues. This time primary dealers put in very weak offers and would not tender bonds at sensible spreads. That usually means their balance sheets are already stuffed with inventory and they have no appetite for more duration risk. In effect the bond market is telling the Fed to raise its policy rate and get inflation expectations back under control.

Why buybacks exist

The buyback programme is relatively new. The Treasury resumed regular buybacks in 2024, the first since the early 2000s, to support trading in older securities that change hands far less often than the most recently issued notes and bonds. By buying back those older issues and financing the purchases with new debt, the Treasury aims to narrow the gap in pricing between on-the-run and off-the-run securities and give dealers an outlet for bonds that are hard to sell. A buyback that attracts poor participation suggests that outlet is not working as intended.

Dealer capacity is the constraint behind it. Primary dealers are the banks obliged to bid at every Treasury auction, and the government debt they hold counts against the leverage limits imposed on them by regulators. As the stock of Treasuries has grown faster than dealers' balance sheets, their ability to absorb selling and make markets has shrunk relative to the size of the market.

Supply is the background to the strain. Federal deficits have kept the stock of marketable Treasury debt growing faster than the economy for years, and each quarter the Treasury must sell enough notes and bonds to refinance maturing debt and fund new borrowing. Every addition lands on a dealer community whose capacity has not grown in step, which is why the market's plumbing now draws the attention once reserved for its prices.

Regulators have debated how much of the strain their own rules cause. The supplementary leverage ratio requires large banks to hold capital against all their assets, including Treasuries, regardless of risk, so a dealer bank that expands its holdings of government debt must hold more capital even though the bonds carry no credit risk. The Securities and Exchange Commission adopted a rule in 2023 requiring central clearing of many Treasury trades, which is meant to free balance-sheet space over time, but the change is being phased in and does little for dealers today.

The memory of March 2020

The system has broken before. In March 2020, as the pandemic hit, investors around the world rushed to sell Treasuries for cash, dealers could not absorb the flow, and the market for the world's safest asset stopped functioning properly for several days. The Fed restored order by buying Treasuries in enormous volume and temporarily easing the leverage rule for banks. The lesson for today is that thin liquidity can turn a steady rise in yields into a disorderly one.

The costs are already visible. Wider bid-offer spreads raise trading costs for pension funds, insurers and asset managers, and they make Treasuries less useful as collateral and as a hedge. Every other borrower pays too, because corporate bonds, mortgages and municipal debt are priced against a Treasury market that now charges more for liquidity.

Some investors are better placed than others. Those with cash to deploy can buy long bonds at yields close to five per cent from sellers who need liquidity. The most vulnerable are leveraged funds running basis trades, which borrow in the repo market to hold cash Treasuries against futures contracts and can be forced to unwind when financing dries up, as happened in March 2020.

How many hikes, not whether

With the 10-year yield close to five per cent and headline inflation picking up, the Fed's next meeting is no longer about whether to raise rates. The argument has moved on to how many further increases will follow.

The strongest objection is that a weak buyback is a plumbing problem, and plumbing problems have plumbing solutions. The Fed and the Treasury could respond to poor liquidity with balance-sheet tools, changes to leverage rules or adjustments to the size of auctions and buybacks, without raising rates at all. That is fair as far as it goes. The yield rose because inflation is not fading, and liquidity measures cannot address that.

The Treasury has tools of its own. It can shift issuance towards bills, which money market funds absorb readily, and away from long bonds that dealers struggle to hold, as it did in late 2023 when yields last approached 5 per cent. It can also resize or pause buybacks. Each option buys relief today at the price of more frequent refinancing later, since heavier reliance on bills leaves the government more exposed to future rises in short-term rates.

The signals to watch are the next auctions of ten-year and thirty-year debt, measures of bid-offer spreads and market depth, the Treasury's plans for future buybacks and the Fed's decision later this month. At 4.95 per cent on the 10-year, the Fed has run out of reasons to wait. It will very probably raise rates at its next meeting, and bondholders should expect more increases to follow before the year is out.