Is A Treasury ‘Intervention’ Imminent?

Janet Yellen is “very focused” on Treasury market functioning.

That’s according to remarks delivered on Monday at an annual SIFMA gathering. Although Yellen described the US financial system as “resilient” despite myriad “uncertainties” in a “dangerous and volatile environment,” she was adamant about the necessity of safeguarding the US government bond market.

“Trading volumes are robust and investors are able to execute transactions,” she said, before adopting a more cautious cadence, as follows:

In the past few years, we have seen some episodes of stress in this critical market. These episodes underscore the importance of enhancing its resilience. Treasury is working with financial regulators to advance reforms that improve the Treasury market’s ability to absorb shocks and disruptions, rather than to amplify them.

It was the second time in two weeks that Yellen felt compelled to address the issue, and it’s no secret why.

The most commonly cited measure of rates vol (Harley Bassman’s MOVE index) and a Bloomberg gauge of Treasury market liquidity are both near levels observed during the COVID panic, suggesting market functioning is indeed impaired.

Read more: World’s Most Important Market ‘One Shock Away’ From Functioning Issues

That’s hardly news to market participants and analysts, who’ve spent months fretting over deteriorating conditions, and years arguing for structural reforms that might help address what it’s fair to call pervasive concerns.

Over the past two weeks (so, concurrent with Yellen’s public remarks), the idea of a new Treasury buyback program has gone what counts as mainstream for a relatively esoteric discussion. Soundbites are starting to move markets. On Monday, for example, the 20-year (which some believe would benefit disproportionately from any buyback plan) responded to Yellen’s comments.

It’s important to consider this discussion in the broader context of a market keen for evidence that policymakers are panicking. Treasury buy backs aren’t tantamount to Fed bond-buying, but the reinstitution of a buyback scheme would nevertheless amount to an acknowledgement that the combination of tighter policy, market uncertainty and legacy issues warrant intervention, regardless of the official rationale or excuse.

Accurate or not, comparisons to the Bank of England’s recent long-dated gilt and linker purchases would proliferate. Indeed, they already have. A “new bull factor for 2023 is Quantitative Tightening slowly morphing into ‘Quantitative Tinkering,’ as central banks are petrified of the market consequences of liquidity withdrawal,” BofA’s Michael Hartnett wrote last week, mentioning buybacks in the same breath as the BoE’s bond-buying to address the UK pension crisis.

One way or another, it’d be hard to disabuse market participants (especially algos, “who” are famously obtuse) that buybacks wouldn’t constitute intervention and thereby aren’t bullish. With positioning in rates still lopsided (short) and the equities options space reflecting a buyside community that’s concerned about missing out on explosive upside, the potential for Treasury buyback headlines to spark a rally is very real indeed.

“The ‘best’ option [for addressing Treasury market functioning] remains debatable, but without question, the idea of Treasury buybacks is ‘trending,’ and picking up velocity in recent days,” Nomura’s Charlie McElligott said Tuesday.

But here’s the thing: The whole “Treasury liquidity is as bad as it was during the COVID panic” talking point (which I’ve obviously parroted myself) may not tell the whole story.

As McElligott’s colleague Ryan Plantz noted earlier this month, Bloomberg’s index (which measures average yield error to show dislocations from fair value) should be a good proxy for liquidity, but in the current environment, it might just be a reflection of volatility. That supposition is supported by the fact that Bloomberg’s liquidity gauge tracks the MOVE and 3M10Y (yellow line in the figure, below) very closely.

“This is not necessarily a great proxy for liquidity but rather for all volatility conditions that are impacted by the Fed’s monetary policy tightening,” Plantz wrote, adding that if you plot “mortgage basis (a short vol proxy) as well as swap spreads (cost of balance sheet)” on top of 3M10Y vol and Bloomberg’s liquidity index, they’re all “headed in the same direction.” Mortgage basis and inverted swap spreads are shown in the figure (above) in purple and red.

Of course, volatility and liquidity are inversely correlated, so there’s definitively a chicken-egg dynamic to sort through. The point, Plantz emphasized, is just that “it’s important not to confuse an increase in volatility and cost of balance sheet with a loss of market liquidity.”

To drive that point home, Plantz looked at bid/offer spreads on a cross section of the market. “We see only a modest widening over the past couple of years — nothing close to what the GVLQUSD Index would have implied in terms of liquidity despite the fact that these tracked each other quite closely during the peak COVID illiquidity window back in 2020,” he said. The figure (below) illustrates the point.

Plantz proceeded to walk through a variety of other metrics in order to get a better sense of whether there actually is a problem or, perhaps more aptly, a problem that needs addressing in an urgent, heavy-handed manner.

He noted a barely perceptible slowdown in volumes, but said that overall, they’re stable, as are interdealer broker volumes, which “suggests to us there has been no drop-off in activity.” At the same time, primary dealer on-the-run positions are stable, which, when taken in conjunction with smaller aggregate holdings, “implies less off-the-runs on dealer balance sheets.”

That latter point is notable to the extent it effectively undermines the case for a buyback program predicated on support for off-the-runs. The better argument for such a program, Plantz suggested, is just that it would give Treasury more operational latitude which, considering the political environment, could be useful, to put it politely.

At the end of the day, it’s important not to overthink things. If it’s volatility, not liquidity, then it’s not terribly difficult to explain. As Plantz put it, “the real issue remains the fact that with the Fed stepping away from the market, the increase in volatility is simply a function of pushing the clearing level for rates back onto private investors instead of the Fed.”

The more optimal solution is probably regulatory reform. I’m sure Jamie Dimon would agree. Michelle Bowman seems to get it. “Leverage ratios that discourage banks from intermediation in the Treasury market, or from holding ultra-safe assets such as Treasurys and reserves, can distort incentives and disrupt markets,” she said late last month. “Addressing these issues could improve market functioning and financial stability.”

Stepping out of the (deep) rough and back into the fairway, it’s not a stretch to say that headlines (particularly of the all-caps Bloomberg variety) tipping or announcing intervention of any kind, whether that means an actual buyback program or even “just” SLR relief, could spark a rally in rates that spills over into equities.

McElligott spelled it out. “Given the ‘short’ base remaining in bonds and STIRS as well as equities from systematic / trend being exposed to mechanical risk-management forced covering, a theoretical headline in the coming days or weeks on ‘intervention’ in UST liquidity would send bonds and equities ripping explosively to the upside,” he said.

Despite what Charlie aptly described as “the larger macro headwinds,” removing (or even reducing) the risk of a left-tail “rates accident” would go a long way towards calming frayed nerves.