“But I’m not going to step in and try to fix the pumpkin market. So,this is the kind of wired thing with liquidity. It’s really talking about no-one’s out there willing to pay the price you’re asking. Okay,that’s fine,just lower the price.”
It has to be said that financial markets are somewhat more complicated than the market for pumpkins at Halloween. They are impacted by regulation,by sentiment,by risk appetites,by participants’ capacity and by highly complex and opaque relationships between markets and different securities,among other influences.
The Bank of England was forced to intervene in the UK bond market last month to avert a foreign exchange and bond market crisis.Credit:AP
There is a demand issue developing in global bond markets and particularly in the US,where the Fedis pursuing the most aggressive monetary policies.
It has raised rates by 3 percentage points since March,with at least another 1.5 percentage points to come,and has been allowing its near-$US9 trillion ($14.3 trillion) holdings of US bonds and mortgages to shrink as the securities mature.
That “quantitative tightening” (QT) started by allowing $US47.5 billion of bonds and mortgages to mature without reinvestment on the proceeds in March but was increased last month to a rate of $US95 billion a month.
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The Fed was,and has been for most of the period since the 2008 financial crisis,the largest buyer of US government bonds and mortgages and ended its QE programs owning about a third of each market. It’s now buying about $US60 billion a month less Treasury securities than it was before its pandemic-related QE program ended in March.
It’s not,however,the only former buyer to have reduced its appetite for Treasury securities.
China,Japan and other governments have stopped buying or begun selling some of their holdings in response to the rapid rises in yields and consequent losses on the market value of the bonds (bond prices fall when yields rise). Governments are also selling US dollar assets,generally Treasuries,to try to limit the extent to which their currencies depreciate and import inflation and instability in the face of a major appreciation of the US dollar.
Commercial banks have also cut their holdings by about $US70 billion since March.
The Fed has taken about $US180 billion of demand out of the market already and is targeting a $US2 trillion-plus reduction in its balance sheet over the next two and a half years. Foreign government have reduced their holdings by about $US50 billion in the past six months and that rate could be expected to accelerate,given the dollar’s strength.
Fed chair Jerome Powell. Central banks around the world remain locked in an inflation fight.Credit:AP
The US Treasury market is a $US25 trillion market and in normal times is stable,with deep liquidity. At present,however,it is more volatile than it has been in decades and shallow – large trades are having outsized impacts on prices – and therefore less of a global haven for capital than it has been historically.
A key question,given that the US Treasury has to continually tap the market as it rolls over or raises new debt,is who will replace the reduced demand from the Fed and foreign governments?
Another is whether the volatility and diminished liquidity in the market might lead to the kind of unexpected financial system events seen in March 2020,or in the UK last month.
A factor in the volatility of a traditionally low-volatility market is the post-2008 reforms to bank capital and liquidity that have diminished the role banks and investment banks now play as dealers charged with the responsibility creating an orderly market.
The Fed and other central banks’ aspirations for a smooth reversal from QE to QT to combat raging inflation rates may not,as the BoE discovered so brutally,be as easy to execute as they hoped or planned.
Another,given the role Treasuries play as benchmarks for other asset classes,might be the linkages between different markets and securities.
In the post-2008 environment of ultra-low to negative interest rates and abundant liquidity the use of leverage by non-bank institutions to amplify otherwise meagre returns was seductive,whether using debt or derivatives.
Post-2008 financial sector reforms have forced most derivative transactions away from private deals between principals and onto platforms operated by central clearing houses that require collateral.
The sea change in bond market conditions this year could,as we saw in the UK,force institutions to dump high-quality collateral (like Treasury securities) to meet margin calls in other markets that are equally,if not even more,volatile.
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The volatility in global bond,equity,currency and property markets could trigger – or be triggering – margin calls that flow back to the bond markets.
The liquidity issues in bond markets that traders are complaining about – and the demonstration provided by the UK experience – point to markets,and financial systems,that are fragile and vulnerable.
The Fed and other central banks’ aspirations for a smooth reversal from QE to QT to combat raging inflation rates may not,as the BoE discovered so brutally,be as easy to execute as they hoped or planned.
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