- Liquidity in the U.S. Treasury market has declined to its lowest level since March 2020, when the pandemic roiled investors and gummed up the market until the U.S. Federal Reserve intervened as a buyer of last resort.
- And a lack of liquidity has exacerbated price swings for the world’s most-traded sovereign debt, leading to conflicting market signals.
Liquidity is one of those things – often taken for granted except when you need it the most.
And the massive US$23 trillion market for U.S. sovereign debt is about to figure out whether it has the liquidity to cope with rising interest rates and a central bank determined to runoff its balance sheet.
Liquidity in the U.S. Treasury market has declined to its lowest level since March 2020, when the pandemic roiled investors and gummed up the market until the U.S. Federal Reserve intervened as a buyer of last resort, according to data from Bloomberg.
And a lack of liquidity has exacerbated price swings for the world’s most-traded sovereign debt, leading to conflicting market signals.
Typically, U.S. Treasuries move inversely to U.S. equities, with a rise in the price of one typically correlating with a price increase in the other – Treasuries and equities are negatively correlated, moving opposite to each other.
But the pandemic and a flood of liquidity by central banks have upended traditional correlations and over the past 24 months, equities and Treasuries have moved in lockstep.
Despite geopolitical uncertainty, such as the Russian invasion of Ukraine, typically serving as a catalyst for heightened demand for haven assets, U.S. Treasuries are on track to post their worst quarter since 1973.
Key to the poor performance of Treasuries of course has been the U.S. Federal Reserve’s interest rate hike this month of 0.25%, its first since 2018, and inflation running at its fastest pace since 1982.
The U.S. Treasury market has also grown increasingly volatile, given the lower levels of liquidity, raising serious questions on the proper functioning of a market that forms the bedrock of global finance, determining the interest on everything from mortgage rates to stock prices.
Treasuries typically rally during times when markets are jittery, with traders stashing their cash in the safest assets.
But the typically in-demand U.S. Treasuries have seen their allure languish as interest rates have risen and as the Fed is preparing to become a seller of these government securities.
Not helping matters is that the financial institutions which have been traditional market makers for U.S. Treasuries have been forced to pull back from that role ever since stricter capital requirements were implemented post-2008 in the aftermath of the financial crisis.
And while hedge funds and high-frequency traders have stepped in to pick up some o the slack, they are a fleeting presence, only hanging around long enough or often enough to clock in profits and exacerbate volatility, rather than moderating the swings in the market.
But the bigger implication of volatile Treasury markets is that it could worsen already tightening financial conditions.
Because a firm can’t (at least in most cases) borrow at a rate that’s lower than what it costs the U.S. to borrow at, it could become harder for companies and consumers to obtain financing cheaply, and that could pose a drag on the U.S. economy, adding to recessionary pressures that higher interest rates are already contributing to.
