QT is here and it is unprecedented. Will the Treasury market wobble?


The Treasury market is the deepest and most liquid market in the world. So, it is expected to have minimal, if not zero, rumblings and cracks in its functioning. Yet, there have been more than a few instances of disruption in the Treasury market (October 2014, September 2019, March 2020, February 2021). Each event was marked by a significant spike in volatility, risk off sentiment and a consequent impact on all asset classes. But the March 2020 Dash-for-Cash episode was arguably the most important of all. Treasuries were being sold broadly and in large quantities to secure cash and liquidity in this all important market was severely constrained.

The largest of all QEs ever undertaken is now behind us (Net purchases of US$4.6 trillion!). The Fed’s holdings of Treasuries and Agency securities totals US$8.5 trillion and 35 percent of nominal GDP. That is double the size in dollar terms and about 10 percentage points higher as a share of GDP than in late 2014.

We are now getting into a tightening phase – more importantly, an unprecedented one (characteristically unlike the last cycle in 2018). There are so many questions that come to the fore.

  • As tightening commences and bank reserves reduce, at what stage will liquidity start to feel scarce in financial markets?
  • Primary Treasury Bond issuance is only slated to increase with ever more fiscal spending. Is market making capacity going to keep up with the issuance, especially when one of the key buyers in the market (the Fed) will be missing?
  • Will occurrence of more episodes of extreme volatility in US Treasuries result in even higher long-term yields? 
  • Most importantly, what happens if rates rise substantially but the ghost of inflation has not yet been exorcised completely? QE or QT then? What is the ripple effect on equities then?

The US risk free rate has always been the foundation of the global investment landscape. But today it is more important than ever! Investors can choose to ignore these risks at their own peril!

The 5 minute summary..

  • The US Treasury market is the single most important financial market in the world as Treasury rates are a fundamental benchmark for pricing virtually all other financial assets
  • There have been a total of 4 relatively major stress events in the Treasury market since 2014 (October 2014, September 2019, March 2020, February 2021), with the March 2020 event being the most significant one.
  • In March 2020, on the back of the onset of the pandemic, Treasury yields spiked massively (for example, the 10-year yield spiked 64 basis points between March 9 and 18 and the 30-year bond lost 10 percent of its market value over March 16 and 17). There was a mad dash for cash, US treasuries were being offloaded to secure cash and market makers in this key market were reluctant to provide liquidity and make markets. In short, the US Treasury market failed to serve as a safe haven and was mired in dysfunction
  • The Fed had to intervene in a rather major way to provide support and liquidity to financial markets. It purchased more than US$800bn in the first three weeks of these operations! And, in any case, large scale QE commenced from April 2020 that has lasted till just now
  • Another key development was the exemption of Treasuries and Reserves from the calculation of the Supplementary Leverage Ratio. The SLR essentially caps the size of a bank’s balance sheet. Altering the SLR calculation gave banks breathing room to take on US Treasuries assets on its balance sheet as a part of its market making activities without having to worry about breaching the SLR.
  • While undoubtedly the lack of market making especially by big banks has been the prime reason for the episodes of Treasury market volatility, there are other factors at play as well. For example, Dealer to Client Treasury market trades are characterized by lack of transparency. Another example is that the overall lack of centralized clearing in the Treasury markets also makes it prohibitive for more participants to act as market makers.
  • There are various measures which are being considered to improve the liquidity and functioning of US Treasury markets. These include – increasing market making capacity in Treasury markets by providing access to repo financing from the Fed to other players beyond Primary Dealers, addressing Bank Regulation (read “modify SLR”) so that banks are not hampered in their market making activities, central clearing of trades of Treasury securities and Treasury repos, improving market transparency and improving market regulation.
  • Any major market dysfunction event will prompt a deep rethink of macro policy stance and risk assets will respond to that. It will be important to follow developments on each of these above measures. Remember the US Treasury market is the foundation of virtually every risk asset.

Geek like me? Read the full article below..

US Regulators are constantly monitoring the Treasury markets and stress events like these to improve Treasury market functioning. The Inter-Agency Working Group is one such task force which comprises members from the Treasury, Board of Governors of the Fed, the FRBNY, the SEC and the CFTC. The IAWG released a progress report on their findings in November 2021 which highlights potential areas of improvement for bolstering the resilience of Treasury markets.

Similarly, the Group of 30 released a report in July 2021 which analyses the current state of the Treasury Market in light of the above mentioned stress events and makes recommendations for increasing liquidity and improve functioning of Treasury Markets. For the uninitiated, the Group of 30 is an independent global body comprised of economic and financial leaders from the public and private sectors and academia. It aims to deepen understanding of global economic and financial issues, and to explore the international repercussions of decisions taken in the public and private sectors. Just to give you an idea, its current members comprise the likes of Tharman Shanmugaratnam, Mark Carney, Mohamed El-Erian, Larry Summers, Paul Krugman, Gita Gopinath, etc.

Key summary points of the IAWG report

  • The common element through most of these events, especially Sep 2019 and Mar 2020, is that there is a sudden surge of liquidity needs and market intermediaries, who are supposed to provide liquidity to the markets, withdraw during periods of stress (either on account of unwillingness to intermediate or lack of capacity to intermediate)
  • In a mad dash for cash in March 2020, investors were liquidating the safest and most liquid of securities. Almost everyone was selling securities to raise cash and liquidity – not knowing what the pandemic holds in store for the world and financial markets in general.
  • Foreign Central Banks, for instance, were also selling Treasuries to raise dollars to meet dollar requirements of their local financial markets and economies
  • Leverage played a key role in the market stress as well. Funds that trade the cash – futures basis are often highly leveraged (because the arbitrage opportunities are so small, that only large leverage driven positions can result in meaningful profit). These trades are also financed in the short term repo markets. Which essentially means that rapid movements in price which cause mark to market losses will result in massive margin calls and further selling of Treasury securities to raise cash and fund those margin calls.
  • The Fed (like multiple times now!) had to step in to cool the markets. Key measures taken – 1. Massive overnight repo operations to provide liquidity to market participants. 2. Start large scale asset purchases (essentially QE again!). The Fed purchased more than US$800bn in the first three weeks of these operations ! 3. One of the most important developments in recent times – The FIMA facility. A temporary repo facility for Central Banks around the world to access dollars. (Once again just demonstrates the core fact that the dollar is not a US only currency, It is a World Currency!)
  • One of the most important measures regulatory agencies took in response to the March 2020 crisis was the relaxation to the supplementary leverage ratio – excluding Reserves and Treasuries from the calculation of SLR which gives banks relief to accommodate the massive liquidity surge and deposits that entered the banking system. This gave the banks (and broker / dealers) the ability to continue to market make in Treasuries
  • Potential changes to the SLR ratio and calculations are being considered. Key to track developments on this front.
  • In July 2021, the Fed announced the creation of the Standing Repo Facility and made the temporary FIMA facility (described above) permanent. The SRF is offered daily against securities eligible for OMO at a minimum bid rate of 0.25%. So in times of stress, the Fed is always ready to lend and provide liquidity.
  • Post the 2008 financial crisis, a large part of the derivatives market moved to central counterparty clearing and that has worked quite well. In similar vein, this report also states that the IAWG, similar to such other recommendations by the public, is looking at ways to expand central clearing of the Treasury market transactions. the Treasury Market Practices Group has estimated that 13% of cash transactions are centrally cleared; 68% are bilaterally cleared; and 19% involve hybrid clearing, in which one leg of a transaction on an IDB platform is centrally cleared and the other leg is bilaterally cleared. While central clearing has its obvious risk management benefits, other aspects like increased costs and the creation of a CCP entity large enough to be systemically important need to be considered as well
  • The last summary point to note in this paper is the substantially larger role played by Principal Trading Firms or PTFs. These PTFs have become the elephant in the room in the Treasury markets. In general, it seems that their ability and willingness to market make during times of stress depletes faster than traditional Treasury market broker / dealers. This is on account of multiple factors, not the least of which is lower capitalization of these PTFs as compared to traditional broker dealers.

Some key summary recommendations of the Group of 30 report

Access to the Standing Repo Facility (and set up of the facility)

  • The willingness and capacity of firms to make markets is critically dependent on their confidence in their ability to fund inventories of Treasury securities that they may acquire as a result of those activities, even during stress. While bank affiliated broker dealers are still the major players in the Treasury markets, expanding Fed repo access to entities other than primary dealers might incentivize more participation in Treasury market making activity. (Note the Fed created a permanent Standing Repo Facility in July 2021 under which Primary Dealers and Depositary Institutions can access Fed repo funding). The terms of the facility should be such that use of the facility is discouraged under normal market circumstances without stigmatizing its use under periods of market stress.

Central Clearing in the Treasury securities and repo market

  • Overall, approximately only 20% of purchases and sales of US Treasury securities are centrally cleared. Principal trading firms (PTFs) account for a very large share of trading, and trades between PTFs and the Interdealer Brokers seldom are centrally cleared. In the Dealer to Client segment of the Treasury securities market, trades are mostly bilaterally settled. Central clearing for a wider range of Treasury market trades can help with counterparty risk management and create additional market making capacity. However, central clearing comes with additional costs in the form of fees and margin requirements which can also disincentivize participation in the Treasury Market. Also, the Central Clearing institution itself becomes extremely large and hence systemically very important and needs to be adequately supervised and managed. FICC, the existing central counterparty for U.S. Treasury securities and Treasury repos, is an SEC-regulated clearing agency and has been appropriately designated as a Systemically Important Financial Market Utility. Wider central clearing would make its safety and efficiency even more important to the functioning of the Treasury market and to U.S. and global financial stability

Amendments to SLR

  • Post-global financial crisis reforms, including the Supplementary Leverage Ratio requirements, have ensured that banks have adequate capital, even under stress. However, the SLR was probably meant to serve as a backstop to banks risk based capital measures. However, the SLR has become the binding constraint for banks to undertake market making activities in US Treasury securities and repos, mostly on account of bloated balance sheet sizes from the increase in reserves from large scale asset purchases. Changes to the SLR might be needed to ensure that the SLR functions as a backstop rather than a constraint that hampers banks market making activities. In the absence of such changes, banks are highly unlikely to allocate more capital to market-making in the Treasury and Treasury repo markets, and thus a regulation that was intended to be stabilizing will continue to undermine the stability of market intermediation.

Happy Investing!

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