Analysis: US Treasury market pain amplifies liquidity concerns


FILE PHOTO: U.S. dollar banknotes are shown in this illustration taken February 14, 2022. REUTERS/Dado Ruvic/Illustration

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NEW YORK, March 24 (Reuters) – A sharp sell-off in U.S. Treasuries raised concerns about low levels of liquidity in the market by $23.5 trillion, potentially magnifying losses for investors who had already experienced an early disastrous year.

Yields on US government bonds have soared this year as the Federal Reserve has been more hawkish about how aggressively it will raise interest rates to cool the economy, which has had an impact on bond yields. The ICE BofA Treasury Index (.MERG0Q0) recorded its worst start to the year in its history, down 6%.

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Although liquidity in the US Treasury market is an ongoing issue, traders and investors said there were particular concerns during this selloff.

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“People who buy longer-dated Treasuries, like repo, central banks, and insurance companies, tend to stay away when you have that kind of volatility,” Ed Al- Hussainy, senior rates and currency analyst at Columbia Threadneedle, adding that liquidity “isn’t good” and trading large blocks of Treasuries “has become very difficult”.

The Treasury securities market is generally one of the most liquid in the world and the global financial system uses these instruments as benchmarks for asset classes. But it has experienced liquidity problems, such as in late February and early March 2020, when pandemic fears caused market disruptions and liquidity quickly deteriorated to crisis 2008 levels, prompting the Fed to buy $1.6 trillion of Treasuries to increase stability.

Investors say liquidity problems this year have not reached the point of threatening market functioning, but concerns have grown over several factors.

The first is that the Fed has stopped buying US Treasuries, after this month ending a bond-buying program aimed at supporting the economy during the coronavirus crisis.

“We are adjusting to this new world where the Fed is not a buyer,” Al-Hussainy said.

Some investors are also concerned that sharp price swings in commodity markets due to the Ukraine crisis and sanctions against Russia, a commodity exporting giant, could create pockets of illiquidity in the financial system. .

“There are a lot of correlation risks that I think have reduced balance sheet availability for the system as a whole, so even Treasuries are affected,” said George Goncalves, head of US macro strategy. at MUFG.

“There’s a reduction in balance sheet capacity because people decrease risk, and when you start to really delve into it, you start to think that there are ripple effects that not only reduce appetite for the risk but also the ability to trade,” he said. noted.

Some liquidity metrics showed strain.

Bid-ask spreads — a commonly used indicator of liquidity — widened significantly in March on short-term Treasuries, according to data from Refinitiv.

Data from the CME Group showed that order book liquidity for Treasuries has declined since Feb. 24, when Russia began its invasion of Ukraine, and volatility has increased.

Cash contract volume in terms of average daily bid/ask quantity for five-year Treasury bills fell to $10 million in March from around $25 million in February.

For benchmark 10-year bonds, liquidity in the backlog fell to an average of $14 million in March from around $20 million in February.

However, relative volumes remained unchanged month-on-month.

Steven Schweitzer, senior fixed-income portfolio manager at Swarthmore Group, said he saw a “pretty big disconnect” on the short end of the US Treasury curve earlier this month – a reminder of the lack of liquidity observed following the global financial crisis.

“Bonds and credit are the lubricant of the economy, and when the short term dries up, that’s a really big red flag for us,” he said.

The weakness in bonds this week came after Fed Chairman Jerome Powell said on Monday that the U.S. central bank needed to act quickly to counter too-high inflation and could use interest rate hikes more important than usual if necessary.

Benchmark 10-year Treasury yields jumped to 2.969% on Monday from 2.153% on Friday, and two-year notes climbed to 2.117% from 1.942%, narrowing the spread between the yields of these two maturities – a sign that the market is anticipating a sharp economic slowdown. Read more

With the Fed looking increasingly determined to fight inflation despite the risk that tighter monetary policy will slow growth, there is less support for Treasuries buying, so selling finds little counterweights to offset them, some investors said.

Expecting higher returns had become a business consensus, investors said.

“People are probably on the right side of this trade now,” said Matthew Nest, global head of active fixed income, State Street Global Advisors.

“The next painful trade is when and if yields come back down,” he added.

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Reporting by Davide Barbuscia, additional reporting by Ira Iosebashvili and Saqib Iqbal Ahmed; edited by Megan Davies and Jonathan Oatis

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