Trouble looms over the $24 trillion US Treasury market

Over the past month, the financial world has focused on the crisis in the United Kingdom. But it is becoming increasingly apparent that a potentially larger catastrophe is developing in the United States.

It is centered on the $24 trillion US Treasury market, where government bonds are traded daily, and serves as the foundation for the global financial system.

There are indications that the conditions that caused it to freeze in March 2020, when there were virtually no buyers for US Treasuries, the purportedly safest financial asset, are returning.

This is reflected in the reduction of available liquidity. Liquidity refers to the ease of doing transactions.

In an essay published at the end of last week by Financial Times columnist Gillian Tett, it was stated that while the market for US Treasury bonds appeared quiet on the surface, in contrast to the chaos in the UK, "some ugly currents are churning in the Treasuries world"

JPMorgan's Treasury market liquidity index has deteriorated to levels not seen since the crisis of March 2020.

In an essay published earlier this month, Robert Burgess, executive editor of Bloomberg Opinion, underscored the severity of the concerns by pointing to "what is swiftly becoming a major crisis in the world's most significant market—US Treasuries."

He wrote, "The phrase 'crisis' is not hyperbole." "Liquidity is vanishing rapidly. Volatility is on the rise. Once inconceivable, demand at government debt auctions is now a source of concern.

Burgess, along with other critics, pointed to the remarks made by US Treasury Secretary Janet Yellen in response to a question during a speech she delivered last week in Washington. Yellen stated that her department was "concerned about a lack of adequate market liquidity."

She stated that although the capacity of broker-dealers on the Treasury market had not grown significantly, the overall supply of government debt had increased.

The Treasury Department made a statement regarding this issue last month. It was stated that between 2007 and 2022, the public's debt climbed from $5.1 trillion to almost $23 trillion.

During the same period, however, the rise of computerized trading and "increased participation by proprietary trading businesses" led to a 50 percent decline in the central clearing of transactions. In other words, an increasing proportion of market activity is occurring in places that are hidden from the view of financial authorities.

"This reduction in market visibility has consequences for systemic risk, particularly in the context of market disruptions," the statement stated, citing the crisis of March 2020 and the events of February 25 of last year, "when the values of Treasures fell dramatically amid tight liquidity conditions."

Fed interest rate hikes are a significant contributor to the deterioration of liquidity conditions. In so-called quantitative tightening (QT), rather than purchasing government debt, the Fed is currently reducing its holdings by $95 billion per month. While quantitative easing (QE) increased liquidity, quantitative tightening (QT) is lowering it.

Burgess also pointed out an additional liquidity loss. He said that the "biggest influential purchasers of Treasuries, including Japanese pension funds and life insurers, foreign governments, and US commercial banks, are all pulling out at the same time."

This issue is exacerbated by the appreciation of the US dollar against the Japanese yen and the Japanese government's efforts to avert a further decline by selling dollar assets.

Recent research by economists Raghuram Raja, a former governor of the Reserve Bank of India, and Viral Acharya of New York University examined the impact of quantitative easing on market liquidity.

As a result of the drop in the Fed's asset holdings, "we could have liquidity issues in the banking sector," Acharya told the Financial Times last month. And whenever banks are under stress, it typically spreads to non-banks, Treasury, and other [financing] markets.

The Bank of America has warned that pressures in the Treasury market might be "one of the greatest dangers to global financial stability today," potentially worse than the 2004-2007 housing market bubble that precipitated the 2008 financial crisis.

The New York Times reported last week that Fed officials have questioned Wall Street specialists as to whether a crisis similar to the one in the United Kingdom could arise in the United States. The Biden administration is conducting its investigation and has received the same message: "The probability of a financial disaster has increased as a result of the significant increase in interest rates by central banks."

Even while the market was not "collapsing," it was difficult to find a buyer for US government bonds fast, and "in areas of finance involving more complex investment structures, there is concern that volatility might unleash a hazardous chain reaction."

According to The Times, Biden "has pressured his team to quantify the likelihood that the United States may endure another Wall Street shock similar to 2008."

Another area of concern is so-called emerging markets, as the rise of the dollar has increased the payments they must make on their dollar-denominated debt, as well as the possibility that this deteriorating situation and the increased risk of defaults could harm the United States.

According to Tett's piece, US regulators are attempting to address deteriorating liquidity in the Treasury markets, and there will be a high-level meeting next month to consider structural reforms. Some of these measures had previously been implemented, such as mandating greater market trades on centralized clearing systems.

She stated, "However, the harsh truth is that these reforms are still moving at a far too modest and slow pace to eliminate structural concerns, especially given that QT is plunging us into new waters."

Tett hoped that the conference of regulators scheduled for next month will aggressively accelerate the pace of reform.

"If not," she concluded, "QT might produce much greater liquidity stress, and... [the] British crisis could be a precursor to a far larger American drama if (or when) new economic shocks strike."