Treasury Market Risks ‘Vicious Liquidity Feedback Loop’

“For risk-free assets to be so risky is bound to be problematic,” SocGen’s Andrew Lapthorne said Monday, while gently noting that even after 2022’s simultaneous selloff, global bond and equity market cap still sits around $17 trillion above a simple trendline.

The idea of bonds as a source of portfolio volatility — the sponsor of an adverse event, rather than a buffer during periods of turmoil — haunted market participants for years. As yields trekked ever lower, bonds’ capacity to offset losses in risk assets diminished.

At the same time, many argued that central banks’ expanding footprint in government securities impaired market functioning and increased fragility, raising the odds of so-called “tantrums” and “flash” events. Some of that criticism is true by definition. At times, the JGB market barely functions, for example. It’s not really a “market” in the traditional sense of the term.

This discussion was something of a campfire ghost story for most of the post-financial crisis era, but now that the macro regime has shifted and central banks are compelled to tighten policy irrespective of the implications for asset prices, the risk of bond instability is real (figure below). Indeed, bonds have been the sponsor of 2022’s equity event.

This is a worry for the Fed as it seeks to shrink the balance sheet. Equity losses are acceptable — desirable, even, as stock declines help tighten financial conditions. If the bond selloff were to become disorderly, though, the Fed would have to step in. A malfunctioning Treasury market is a total non-starter.

Unfortunately, conditions are in fact deteriorating, raising the risk of what TD’s Priya Misra and Gennadiy Goldberg called a “vicious feedback loop.”

“Liquidity conditions have deteriorated significantly due to market structure issues,” they wrote, flagging liquidity provision by Principal Trading Firms whose “activity tend[s] to shrink when vol picks up” and a lack of dealer balance sheet due to familiar SLR constraints.

Note that Bloomberg’s Treasury Liquidity Index, which measures deviations in yields from a model of fair-value, is now at post-pandemic panic highs (figure on the left, below).

“This has prompted many investors to stay away from trying to fade price action, which has in turn led to greater market volatility,” Misra said, noting the steady rise in implied vol.

Of course, if investors “stay away,” that means the market stays thin. And a thin market is conducive to the very same elevated volatility that’s keeping investors on the sidelines in the first place. Throw in outflows from bond funds, and you’re left to ponder the very same volatility-flows-liquidity feedback loop that so often plays havoc in equities.

So, who’s going to buy? This is a falling knife, after all. US Treasurys are in the middle of their worst drawdown ever. Foreign investors are reluctant for a number of reasons. The global bond selloff means Treasurys are no longer the only game in town when it comes to safe debt with nominal yields in positive territory and FX hedging costs are a factor. Fund outflows aren’t likely to abate until the market stabilizes, and that’s self-referential given that outflows are one source of pressure. Banks may be reluctant “due to a slowing in reserve growth and OCI losses given the selloff in rates and widening in MBS basis,” Misra said, adding that while money market funds will absorb bill supply, they won’t be much help when it comes to filling the demand void for duration.

Ultimately, TD suggested that short circuiting the pernicious feedback loop described above may be a macro matter. Misra said evidence of slower US inflation might ease concerns around the scope of the Fed’s planned trip into restrictive territory, while slower activity in China could spill over to global growth, thereby bolstering the case for long-end bonds. Finally, TD floated the idea that eventually, policymakers might “sound less hawkish,” but conceded that in the near-term, the Fed “wants to stress its commitment to price stability.”

Misra called the marginal Treasury buyer quandary “the trillion-dollar question.” At least for now, I’m not sure there’s a convincing answer. That, in turn, leaves the long-end vulnerable, any local stabilization aside.