Headwinds to the liquidity in the US treasury market

There have been many reports recently that liquidity conditions in the treasury market have become troublesome again

These strains have happened at a time when yields have actually been quite stable and hence it could be a worrying sign of what’s to come if the monetary policy normalisation process creates significant volatility in yields.

There have been many reports recently that liquidity conditions in the treasury market have become troublesome again, especially in the already less-liquid areas of the market like inflation-protected securities or the fairly new 20-year segment of the curve. We have seen bid/offer spreads widen a bit and the 20-year yield has moved above the – more liquid – 30-year bond for the first time since the 20-year was re-introduced last May (the previous 20-year sale was back in 1986).

Much of this happened ahead of the Fed’s tapering announcement last week; something that seemed to go quite smoothly. Of course, the Bank of England’s slightly surprising decision not to hike rates the day before the Fed meeting led to some volatility in the front end of the UK curve and that seemed to spill over to treasuries but, by and large, these liquidity strains have emerged at a time when yields are still pretty stable. It makes you wonder what might happen to liquidity – and the spillover effects this could have – if yields really start to move significantly.

One obvious scenario through which this can happen is if the Fed were to suddenly increase its rate-hike urgency because it felt it risked falling behind the inflation curve. Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said that anticipation of such a scenario could clearly create an environment of surging yields, at least at the front end, as markets discount much faster Fed rate hikes and this upward pressure in yields could be compounded if liquidity strains start to lift bid/off spreads materially.

One particular problem would be in the less-liquid TIPS market as liquidity-related volatility here could create volatility in breakeven rates and leave the market – and Fed policymakers – more uncertain about just how the market was viewing future inflation risks. There could be spillovers to other markets as well as firms and investors scramble for dollar cash. For instance, a recent paper from the Bank of England shows how investors first appeared to cash in US corporate credit during the early Covid tumult last year to satisfy their demands for dollar cash, with liquidation of other corporate credit markets somewhat behind1. No doubt the Fed would be able to supply extra dollar cash. Internationally, this could be achieved via central bank dollar swaps and/or the treasury repos that most foreign central banks can do with the Fed now. But just whether this would be sufficient to ease the strains is a difficult question.

“We could, for instance, see the dollar spike substantially higher, should these liquidity issues increase the safe-haven appeal of the dollar, which may well happen if liquidity strains in treasuries pale into insignificance against liquidity strains it provokes in other assets that are traditionally a lot less liquid, like emerging market credit for instance”, Mr. Steve Barrow said.

In Mr. Steve Barrow’s opinion, this scenario shows the sort of nightmare situation that could evolve if the Fed falls too far behind the inflation curve and attempts to “catch up” with aggressive policy tightening. The question, of course, is whether the enormity of this weighs on Fed policymakers as they consider their actions. In other words, will they be tempted to leave the punch bowl out just that little bit longer than many might expect, or other central banks might do? If the answer is ‘yes’ as we suspect, the chances of an aggressive, if temporary spike higher in the dollar may be diminished.