The next Fed crisis is brewing in US Treasuries

Markets have been skewed in recent weeks, first by rhetoric that a cooling labor market would allow the Federal Reserve to ‘walk away’ from its aggressive interest rate hike campaign, then by comments central bankers that such a move would be premature – as evidenced by Thursday’s Consumer Price Index report. Perhaps there is a solution that would allow the Fed to continue to fight inflation while tackling what is quickly becoming a potential crisis in the world’s most important market, US Treasuries. .

The word “crisis” is not hyperbole. Liquidity evaporates quickly. Volatility is skyrocketing. Once unthinkable, even demand at government debt auctions is becoming a concern. The conditions are so worrisome that Treasury Secretary Janet Yellen took the unusual step on Wednesday of expressing concern over a potential trading breakdown, saying after a speech in Washington that her department is “worried about a loss of adequate liquidity” in the $23.7 trillion market for the United States. state titles. Make no mistake, if the Treasury market crashes, the global economy and financial system will have far bigger problems than high inflation.

But rather than slowing or even stopping the pace of rate hikes, which would only resuscitate the idea that there is indeed a Fed put to bail out investors, the central bank could choose to slow quantitative tightening. While quantitative easing, or QE, injects liquidity into the financial system through bond purchases, QT has the opposite effect. Instead of selling bonds, the Fed is letting the roughly $9 trillion of US Treasuries and mortgage-backed securities it has accumulated on its balance sheet since the 2008 financial crisis mature without replacing them. The amount of QT made by the Fed peaked at $95 billion per month in September, down from $47.4 billion.

The thing is, just as there is no strong evidence that many years of QE have had the desired effect of triggering inflation, QT is unlikely to help temper inflation. What it is more likely to do – and is probably already doing – is wreak havoc on the government bond market, the benchmark for all other markets that determine the cost of money for investors. governments, businesses and consumers.

A Bloomberg index shows that liquidity in the Treasury market is worse now than at the start of the pandemic and lockdowns, when no one knew what to expect. Likewise, implied volatility as measured by the ICE BofA MOVE index is near its highest since 2009. And in an unusual development that shows just how dysfunctional the Treasury market has become, newer securities and more liquid securities, known as short-term notes, are trading at a discount to older, harder-to-trade obsolete securities, according to data compiled by Bloomberg. Daily swings in interest rate swaps have become extreme, proving further evidence of the disappearance of liquidity.

What should worry the Fed and the Treasury Department the most is the deterioration in demand at US debt auctions. A key metric called the bid-to-cover ratio during Wednesday’s government bid of $32 billion in benchmark 10-year bonds was more than one standard deviation below last year’s average, according to Bloomberg News. . Demand from indirect bidders, generally considered a proxy for foreign demand, was the weakest since March 2021, according to data compiled by Bloomberg. Although the Treasury is in no danger of suffering a “failed auction”, weaker demand means the government is paying more to borrow.

This all comes as Bloomberg News reports that the biggest and strongest buyers of Treasuries — from Japanese pensions and life insurers to foreign governments and U.S. commercial banks — are all pulling out at once. “We need to find a new marginal buyer of Treasuries as central banks and banks as a whole exit the stage,” said Glen Capelo, who spent more than three decades on the bond trading desks of Wall Street and is now managing director of Mischler Financial. Bloomberg News.

The US bond market, which sets the tone for debt markets around the world, is not alone. The turmoil in UK gilts over the past two weeks has laid bare the liquidity crunch that was bubbling in most major sovereign debt markets. From the Fed’s perspective, it’s probably reluctant to tinker with QT for fear of being seen as more concerned with bailing out Wall Street’s big cats than controlling inflation. But, again, QE and QT have been shown to have more impact on the proper functioning of the financial system than on the real economy. And it’s not like the Fed hasn’t tweaked its QT program before to deal with market plumbing disruptions. Recall that in 2019, the central bank halted QT and flooded the banking system with liquidity to stop a large and troubling rise in repo rates that led to undue stress. Another option is for the Fed to use its permanent repurchase facility to provide a backstop to the Treasury market, which Yellen says “may be helpful.”

The thinking among market participants is that the Fed will keep raising rates until something “breaks”. That something is looking more and more like it could be the Treasury market, which would be the worst-case scenario on anyone’s dashboard. Time is running out for the Fed to act.

More from Bloomberg Opinion:

• UK can’t afford to look so ridiculous: John Authers

• What happens after a week that shook the world: John Authers

• The strong dollar is about to pay dividends: Robert Burgess

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Robert Burgess is the editor of Bloomberg Opinion. Previously, he was Global Editor of Financial Markets for Bloomberg News.

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