By Davide Barbuscia and Gertrude Chavez-Dreyfuss
BOSTON (Reuters) – Participants in the U.S. bond market are concerned that market liquidity will continue to deteriorate as the U.S. Treasury continues to issue large amounts of debt to cover deficit spending while traders struggle to keep up with the market’s bloated size.
Liquidity – or the ability to trade an asset without significantly changing its price – has deteriorated in recent years. U.S. Treasury prices have fluctuated wildly since the Federal Reserve began raising interest rates to curb inflation, and the issue was discussed on several panels at the Fixed Income Leaders Summit in Boston on June 13 and 14.
Regulators and the Treasury itself have launched a series of reforms to improve trading conditions and avoid disruptions in the world’s largest bond market, the bedrock of the global financial system. Still, many are concerned that vulnerabilities revealed in previous incidents, such as in March 2020, when liquidity deteriorated rapidly due to pandemic fears, could resurface in the event of spikes in volatility and when demand cannot keep up with supply.
“I’m concerned about the liquidity of the markets,” Chris Concannon, CEO of MarketAxess, an electronic fixed income trading platform, said at the conference. “Currently, we’re issuing Treasuries to pay interest on Treasuries … and when you look at the players that are supporting the liquidity, they’re not getting any bigger,” he said.
The U.S. Treasury bond market has more than doubled in the past decade, from $12.5 trillion in 2014 to $27 trillion at the end of May, according to data from the Securities Industry and Financial Markets Association. According to the Congressional Budget Office, the national debt could grow to $48 trillion by 2034.
On the other hand, dealers’ brokerage capacity is limited due to higher capital requirements that prevent banks from holding large positions.
In addition, the yield curve remains highly inverted, meaning that short-term debt yields higher than longer-term bonds. This provides a further incentive for banks not to engage in the so-called duration or interest rate sensitivity of their positions.
“There’s no carry, so why own this stuff? It’s a drain on the balance sheet, you’re not making money,” says Harry Melandri, a consultant at MI2 Partners, a macroeconomic research firm.
“If we have a market where there is a lot of selling going on, for whatever reason, market makers are not going to be happy to drive up sales,” he said. “I’m not saying it’s a problem today or tomorrow, but the vulnerability is there.”
After improving late last year, when Treasury bonds rose in anticipation of rate cuts, liquidity has deteriorated in recent months, according to an analysis by Steven Abrahams, head of investment strategy at Santander US Capital Markets. He calculates liquidity by measuring deviations between certain Treasury yields: in illiquid markets, deviations tend to persist, while in liquid markets they quickly disappear.
Researchers at the New York Fed said in a paper last year that yield volatility explains most of the fluctuations in liquidity in the U.S. Treasury market. But they also noted “a significant loss of functionality in the U.S. Treasury market when intensive use of dealers’ balance sheets is required to broker bond markets, as was the case in March 2020.”
James Fishback, co-founder and chief investment officer of multi-asset investment firm Azoria Partners, says liquidity is currently “fine” but he fears it could deteriorate dramatically due to increasing government bond issuance.
“What happens if there is an auction of US Treasury bonds and nobody shows up? That is a real problem. And that is where liquidity really matters,” he said.
(Reporting by Davide Barbuscia and Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Andrea Ricci)