Mon. Dec 6th, 2021


U.S. government bond specialists are beginning to worry about how the world’s most important market will fare when the Federal Reserve withdraws its support from the pandemic.

The $ 22 ton Treasury brand forms the basis for pricing other assets around the world. It is known for its liquidity – a broad term that means it is easy to get in and out of the trade. But since Covid-19 first hit, there have been gaps in liquidity, causing raging price movements.

As the Fed begins to reduce its $ 120 billion-a-month bond buying scheme, possibly as early as November, some participants fear that the lack of once-reliable market support could cause more instability.

The Treasury market system “is aimed at attracting high-frequency traders and primary traders when there are problems,” says Yesha Yadav, a professor at Vanderbilt Law School in Nashville who studies the market structure and regulation of the treasury.

‘The way it was set up failed. It is extremely fragile, “said Yadav.

The Treasury market has seen the 2020 Covid shock. This was perhaps the inevitable consequence of investors worldwide rushing to reform portfolios. But central banks and regulators were also concerned when treasury prices fell sharply at one point – the opposite of typical patterns in times of stress – as liquidity evaporated. More recently, in February, the poor use of a standard seven-year debt auction caused a significant price drop.

“For people who have March 2020 and February 2021 fresh in their minds, it reminds people that there are risks to the functioning of the treasury as we see the Fed trying to remove itself from the market,” says Mark Cabana, head of the US interest rate strategy. by Bank of America.

The most important responsibility here lies with so-called primary dealers, the 24 financial firms tasked with providing a stream of buying and selling prices for Treasuries through the Fed. These include banks such as JPMorgan Chase, Citigroup and Goldman Sachs. Data from the financial industry regulator indicates that they withdrew in February and March last year before the Fed stepped in to stabilize the market.

Primary traders trade directly with the department of treasury, and they theoretically help to stop the market as buyers when other investors try to sell. But Dodd-Frank regulation in the wake of the 2008 financial crisis has forced banks to keep more capital on their balance sheets to repay the debt they own. In response, primary traders have reduced the debt they carry in proportion to the size of the Treasury market.

Line chart of ratio of positions in the repo market compared to total outstanding debt showing that primary trader positions in Treasury have dropped dramatically

“The banks have never been there to catch the knife, but they were certainly a pretty big liquidity buffer for the market in a way they can not or do not want to do today,” said Kevin McPartland, head of market structure and technology. . research at Coalition Greenwich.

The Securities Industry and Financial Markets Association, an industry firm representing large lenders, wrote earlier this year that the changing bank balance rules will ensure a smooth functioning of the market.

“A modest weakening of the primary trader’s balance sheets is likely to help reduce this more frequent volatility, and we will still have a much safer system than before the financial crisis,” said Tyler Wellensiek, global head of tariff market structure at Barclays. .

But enforcing the rules brings benefits: the capital requirements imposed on banks are likely to have prevented major crises in the sector during the coronavirus recession, according to the Bank for International Settlements. And changing capital requirements could potentially violate the US breach of the Basel international agreement after 2008, says Greg Peters, co-investment officer at PGIM Fixed Income.

As primary traders withdrew their market-determining role, hedge funds and high-frequency traders, including Citadel Securities, Virtu Financial and Jump Trading, took their place. But if markets become volatile, high-frequency trading funds can pull out as well.

Data from Coalition Greenwich show that the volume of the order book – much of which is high-frequency trading activity – has shrunk during recent liquidity problems. In March last year, the average daily order book volume on a relative basis compared to other execution methods dropped to the lowest level since 2014 and has not fully recovered since.

Regulators have discussed making changes to strengthen the liquidity of the treasury market. But progress with all these reforms has been slow and the lack of a centralized treasury market regulator can cause confusion.

Yet not everyone expects a crisis.

“It was very well telegraphed by the Fed,” said Jan Nevruzi, a strategist at NatWest Markets. This communication is likely to prevent a detachable tantrum of the kind seen in 2013.

The Fed’s reverse repo program – which enables banks to put cash in the US Federal Reserve in exchange for Treasuries – could stabilize liquidity in the event of a crisis, says Ellis Phifer, a market strategist at financial advisory firm Raymond James .

But the reverse repo facility is a setback, says Edward Al-Hussainy, an analyst at Columbia Threadneedle Investments, and not a permanent solution for market functioning.

“This is not a market that is ready for the kind of environment in which we operate,” Al-Hussainy said. ‘We see events that are supposed to be rare, with an alarming frequency.

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