Ever since the US inflation rate started to spiral out of control, forcing the Fed to begin an aggressive cycle of raising interest rates and shrinking a balance sheet bloated by its response to the pandemic, and in March 2020, when it tightened US finances system, two-year Treasury bond yields have been particularly volatile.
It is the security that best reflects the market’s reaction to the Fed’s actions, expectations of its future decisions, and the near-term outlook for interest rates and inflation.
Perhaps unsurprisingly, the New York Fed found that the bid-ask spreads on these debt securities (the difference between what a buyer is willing to pay and what a seller is willing to accept) have compared to their historical average and levels in March 2020.
The depth of market for these notes – the amounts of securities available for sale at the best bid and ask prices – was similar to March 2020, and the readings, which reflect the price impact of trades (where higher prices indicate lower liquidity), were for the significantly higher two-year notes for March 2020.
So, judging by a moment commonly referred to as a crisis, which forced the Fed into a near-unprecedented response, conditions in the market for these two-year notes are less liquid.
They’re also more volatile, with the paper saying volatility has been particularly high compared to the history of trading in two-year securities, citing the importance of near-term monetary policy uncertainty to the market in these notes.
This year has created a new environment for investors, whether in bonds or other securities. They have seen nothing but ultra-low interest rates and massive central bank liquidity injections since the 2008 financial crisis – until now.
Now interest rates are rising rapidly and this liquidity is being withdrawn. The pandemic and, more recently, the war in Ukraine ignited inflation, prompting central banks to halt and reverse course their purchases of bonds and other securities – the policy known as quantitative easing.
In the case of the Fed, after adding nearly $5 trillion in assets to its balance sheet in response to the pandemic, it is now shedding them by maturing the securities without reinvesting the proceeds. It has begun “quantitative tightening” at a target rate of $95 billion per month.
For the US Treasury market, this means that its biggest buyer, the Fed, is pulling out. The Fed once bought 40 percent of the issued securities in the market.
Other central banks, most notably Japan (which is the second largest holder of government bonds) are also selling US dollar assets to defend their currencies as US monetary policy is faster and more aggressive than their own and with currency depreciation, elevated inflation and the threat of currency losses threatens higher costs for purchasing commodities or servicing US dollar-denominated debt.
Commercial banks and other institutional investors, unsure about the outlook for monetary policy and the US economy, sit on the sidelines.
Not at all surprising that there has been illiquidity and increased volatility in the market when there are fewer buyers and – because the US government’s borrowing due to the pandemic relief effort and fiscal stimulus by the Trump and Biden administrations in the Skyrocketed – massive increase in the volume of securities sold.
The structure of the market has also changed. The post-2008 banking reform means that banks, which historically acted as primary dealers, have to hold more capital for their financial market exposures, making it more expensive for them to provide liquidity.
They have been replaced by high-frequency traders and hedge funds, whose activities are inherently more volatile and leveraged, which would result in yield movements and levels of available liquidity amplifying in moments of stress.
US Treasury Secretary (and former Fed chair) Janet Yellen said she was “concerned about a loss of adequate liquidity in the market” and worried enough that the Biden administration is considering a range of potential reforms to improve functioning and transparency to improve the market and bring the non-bank actors into the regulatory net.
Reforms would improve the market’s ability to absorb shocks and disruptions, rather than amplify them, she said.
Although the bond market has been more volatile and less liquid, it has yet to malfunction, although participants are concerned that the continuation of quantitative tightening, ongoing selling by foreign central banks and investors, and the possibility that interest rates will continue to rise well beyond Die current expectations could crash the already fragile market, with repercussions across the world’s financial markets.
That would, of course, force the Fed to step in again and, as it has since the 2008 crisis, bail out the markets and investors in general. The “put” option on the Fed, which investors took for granted for more than a decade, would come back into play.
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