Thursday 29 December 2022
This article draws on insights from the FT Film “Fractured markets: the big threats to the financial system“
Summary
There are concerns that a policy mistake could lead to a a sell off in the currently illiquid, US Treasury market, similar to that seen in British Gilts in September 2022. Were this to happen, it could have devastating consequences for a long list of funding markets that base their rates on USTs.
The inflationary backdrop also limits what the Fed and US Treasury might be able to do to support the market without fuelling inflation further.
The backdrop: Inflationary pressures limit fiscal support; falling oil and end of China’s zero-COVID should help
No low interest rates anymore
These were caused by:
- Fed cutting base rates and
- US treasury buying US government bonds
Now have double digit inflation
These started because of:
- People wanting to spend on things (during lockdowns) and experiences (after)
- People leaving the labour market so:
- less staff at ports to process goods arriving, reducing the supply of goods, thus increasing the price of goods
- employers offering higher pay to staff – wages are rising faster than the Fed’s 2% target growth rate, as can be seen in the St Louis Fed data.
- Energy supply reduced as a result of the war in Ukraine.
But inflation looks likely to decline from here because…
- While spending on services is holding up, spending on goods is slowing.
- Both Brent crude prices and West Texas oil prices are back down to the levels seen at the start of 2022.
Key Risk: UST market is now bigger and more illiquid than ever
Liquidity is already low in the US Treasuries market- traders are complaining it is hard to execute orders without moving the price (Exhibit 1).
The main cause of this reduced liquidity were the regulations enacted following the global financial crisis which required banks to set aside minimum levels of capital (including US Treasuries) against assets. This discouraged banks from acting as intermediaries in the US government debt market.
Exhibit 1: Liquidity in USTs dried up following enactment of post-GFC bank regulations
If trading were to cease for a prolonged period it could prove disastrous.
Potential consequences have been well laid out in a recent note by Bank Of America:
“If the Treasuries market fails to trade for a period of time, various credit channels, including corporate, household, and government borrowing and securities and loans would cease. This could lead to events such as US government debt default…inability to convert Treasuries to cash or meet corporate, household, or government obligations globally, the inability to produce SOFR, which forms the backbone of the $125 trillion USD derivatives market, the inability to issue, trade, or hedge debt of corporates, municipalities, insurance companies, banks.”
Bank of America note, 7 September 2022
In 2001 US Treasury debt outstanding was $3T (30% of GDP). In 2022 it is $23T (100% of GDP). The plumbing of the intermediation of the market — the amount of capital allocated to market-making — has not expanded at the same pace. This has made the UST market very illiquid at points like Mar-20 or Sep-19.
Potential trade: How much do 3 year Put Options on the 10-year US Treasury cost?
-With the US Treasury no longer buying USTs in the open market, and the Fed raising rates there is already downward momentum – yields on the 10y UST are up from 1.5% to 4% in 2022.
-In the event of a war, bond issuance would likely increase, causing prices to fall further.
-In the event of a policy error, causing a rapid sell of in USTs – similar to the LDI debacle in the UK in September 2022 – US Treasury bonds could fall c.10% in a day.
The Equity Analyst 