Control Panel: Treasury bond liquidity, potential crisis

The U.S. Treasury debt market is the largest and most liquid market of any security. It’s the foundation of the U.S. financial system. Treasury holders in international as well as U.S. markets assume that they will quickly find buyers when they need to sell Treasuries to raise cash. Anything that reduces the liquidity of the Treasury market could potentially cause a financial crisis.

The Federal Reserve is raising interest rates by raising the fed funds (short) rate and gradually selling Treasuries and mortgage bonds from their bloated book.

Rocky Treasury-Market Trading Rattles Wall Street

Mounting illiquidity raises concerns over a key market’s functioning should a crisis erupt

By Matt Grossman and Sam Goldfarb, The Wall Street Journal, Oct. 30, 2022

Rising friction in the $24 trillion market for U.S. government debt is stoking concerns for investors throughout financial markets.

The ranks of traders ready to buy and sell Treasurys are shrinking. Individual trades are moving prices more. Treasury securities with similar characteristics are trading at larger-than-normal price differences. Major players, including the big banks and asset managers that have long been significant buyers, are in retreat…

Climbing Treasury yields have recently sent mortgage rates above 7% for the first time in two decades, slashed stock valuations and slowed corporate borrowing. While there hasn’t been a serious breakdown in Treasury trading so far, the possibility is far from unthinkable given the tumult this year. Many traders and portfolio managers warn that such a development would tear through other markets, potentially requiring intervention from the Federal Reserve to prevent a full-blown financial crisis…

Theoretically, a five-year note sold this year should trade at the same yield as a five-year-old 10-year note, because both come due in 2027. But fresh Treasurys are trading at a growing premium to older notes, a sign the older securities have become harder to find buyers for…[end quote]

This information has practical investing implications.

  1. If I want to buy Treasuries and/or TIPS later this year (which I likely will) I should shop in the secondary market rather than placing an order at a Treasury auction. This would be similar to the TIPS I bought in October 2008 on the secondary market which yielded 3% above the inflation rate – a yield which has not been matched since then.

  2. The Fed is counting on being able to raise interest rates smoothly. Hopefully with a “soft landing” but maybe with a recession. They are not trying to cause a financial crisis but they may get one anyway if the Treasury market locks up. METARs need to keep an eye on financial stress and Treasury yields which are a sensitive indicator. That would affect the bond market first but could quickly spill into the stock market.

Real gross domestic product (GDP) increased at an annual rate of 2.6 percent in the third quarter of 2022 (table 1), according to the “advance” estimate released by the Bureau of Economic Analysis. In the second quarter, real GDP decreased 0.6 percent.

The GDP estimate released on 10/27/22 is based on source data that are incomplete or subject to further revision. The “second” estimate for the third quarter, based on more complete data, will be released on November 30, 2022.

The increase in real GDP reflected increases in exports, consumer spending, nonresidential fixed investment, federal government spending, and state and local government spending, that were partly offset by decreases in residential fixed investment and private inventory investment. Imports, which are a subtraction in the calculation of GDP, decreased.

The stock and bond markets were happy with this news and bounced higher. VIX declined. Treasury yields fell and the yield curve dropped along its entire maturity. Financial stress fell a little.

The Fear & Greed Index was in Greed. The trade was somewhat risk-on as stocks and junk bonds rose relative to Treasuries while the USD fell.

The METAR for next week is autumn weather, a mix of sunshine and rain. The market has a sunnier outlook but it’s only a few days until the Fed raises the fed funds rate by 0.75% due to high inflation and the strong economy. Even though everyone is expecting that the market will probably react negatively.

There’s no sign of a crisis…yet.