It's Time To Fix The World's Most Important Market

Investors are experiencing a great deal of unease at the moment due to the wild gyrations in Treasury securities. The Federal Reserve can do a lot to alleviate the situation.

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US Treasury securities are acting as if they have become panic-stricken children who have been told to go back to bed by their parents because they heard a sound go bump in the night. Rather than the thermometers taking the temperature of the economy, these securities act like panic-stricken children.

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Last week, the benchmark two-year note's yield oscillated by an average of about half a percentage point between its highs and lows. Generally, the ICE BofA MOVE Index showed the highest level of implied volatility since late 2008, during the peak of the global financial crisis. Usually, a move of a couple of basis points is considered significant for security. Adam Levinson, a veteran macro trader who has operated a hedge fund for decades, is closing it, according to Trade Algo.

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During the past few weeks, the Treasury bond market has seen some historic swings, as volatility soars near record levels in the market

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A lot happened in the bond market this week, as well, including a few banks runs at mid-sized American lenders, which prompted the government to take over and bail out a few of these banks; and also, a crisis at Swiss-based Credit Suisse Group AG over the weekend which resulted in a forced merger with rival UBS Group AG. There is also the issue of stubbornly high inflation, as well as whether the Federal Reserve will ignore the rising chances of a recession and add more gasoline to the fire with another increase in interest rates this week, or whether it will ignore the rising odds of a recession by taking no action at all.

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The bond market's gyrations, however, are undoubtedly one of the main reasons for the unease that permeates all financial markets today. In the end, the Treasury market is the market from which all other markets draw their inspiration -- from equities, credit, currencies, etc. As strange as it may seem, given how central Treasury securities are to the global financial system, it is a lack of liquidity that exacerbates movements in prices and yields, which results in massive fluctuations in the bond market.

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There has been a widening gap between sellers' offer prices and their acceptance in the $24 trillion cash Treasury market, Trade Algo reported, suggesting a thinning market. Analysts at JPMorgan Chase & Co. wrote Tuesday in a research note, "Liquidity is significantly compromised." That's a bit understatement. Compared to the early days of the pandemic, trading liquidity for Treasuries has declined five times since 2021.

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The government bond market is experiencing its worst liquidity since the financial crisis, apart from the early days of the pandemic

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The Federal Reserve can help. In the debate over monetary policy, the Fed will decide whether to raise rates another quarter of a point or remain on hold when they announce their decision on Wednesday. Maybe the quantitative tightening program should be slowed or even paused instead. QT has the opposite effect from quantitative easing, which injects liquidity into the financial system through bond purchases. In lieu of selling Treasuries and mortgage securities outright, the Fed has allowed the $9 trillion of securities it has accumulated since 2008 to mature without replacing them. A total of $95 billion of quantitative easing was conducted by the Fed in September, up from $47.4 billion in August. In the first week of this month, the Fed's holdings fell by approximately $650 billion to $8.34 trillion. 

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A smaller Fed balance sheet means more bonds are being sold on the market by the Fed

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The Fed's efforts to contain inflation would be counter-productive if QT were slowed or paused. Not likely. Just as QE didn't spark inflation, QT is unlikely to temper inflation. Rather than contributing to excessive volatility, it will likely contribute to excessive volatility in the government bond market — a market that determines government, company, and consumer costs of money. Furthermore, it would be better to tweak QT than to hold off on raising rates. In addition, an abrupt pause in rate hikes could revive the notion that there is, in fact, a "put" by the Fed that will bail out Wall Street at any sign of stress.   

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For years, liquidity has been shrinking due primarily to the Fed's QE program. A massive amount of bonds were pulled out of the financial system, increasing the Fed's balance sheet assets from $1 trillion in 2007 to $9 trillion by 2022, resulting in a collapse in volatility. While marketable debt has grown from $4.5 trillion to $24 trillion, the amount of Treasuries traded among primary dealers has remained relatively unchanged since 2009.

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Despite rising US debt outstanding, primary dealers still trade a similar number of Treasury bills

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Traders, however, are dependent on volatility. Due to this, experienced bond traders who could navigate turbulent markets left the business as their paychecks plummeted. It was no longer possible to attract Wall Street's brightest and best to the famous bond desks that Tom Wolfe described in "Bonfire of the Vanities" and Michael Lewis in "Liar's Poker." The result is that the market is now dominated by relative newcomers who are used to a market controlled by the Fed, with zero interest rates and quantitative easing. 

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There is a lot on the Fed's plate right now, but the liquidity crisis in the bond market is a critical issue that cannot be ignored or put off. Having a Treasury market meltdown will have a much bigger impact on the global economy and financial system than some bank runs.