NEW YORK–Traders are expressing increasing concerns over the world’s largest and most important government bond market, as Fed continues to remove one of its primary pandemic supports, according to a new report.
Since the global economy hit the brakes in March of 2020 as the pandemic spread, the U.S. Treasury market — the $25 trillion bedrock of the global financial system — broke down, noted the New York Times, adding sellers struggled to find buyers, and prices whipsawed higher and lower. In response, the Fed stepped in, devoting trillions of dollars to steadying the market.
“The importance of the Treasury market is hard to overstate. It is the main source of funding for the U.S. government and underpins borrowing costs around the globe, for a huge variety of assets,” the report, noting Treasuries affect rates on credit cards, commercial loans, and just everything with an “interest rate attached to it. The proper functioning of this market is paramount.”
Values Could ‘Tumble’
According to the Times analysis, at its worst, a Treasury trading breakdown could cause the value of the dollar, stocks and other bonds to tumble. Economies that borrow a lot in dollars and hold Treasuries in their reserves would teeter. Crucially, the U.S. government could find it hard to finance itself, even up to defaulting on its debt, the financial equivalent of an earthquake, the report added.
“While this sounds like a bad science-fiction movie, it is unfortunately a real threat,” Ralph Axel, an interest rate strategist at Bank of America, wrote in a research report last week, according to the Times. The report noted Axel sees emerging strains in the Treasury market as “the single greatest systemic financial risk today,” with the potential to do more damage than the housing turmoil that preceded the 2008 financial crisis.
‘Reversing Course’
During the pandemic the Fed’s balance sheet ballooned from a little over $4 trillion in early 2020 to a peak of nearly $9 trillion two years later.
“Stability also brought investment back to the stock market, enriching investors and helping stoke inflation,” the report stated. “Now, the Fed is reversing course through quantitative tightening, or Q.T., pulling back its support for financial markets while it raises interest rates to quell inflation. Some investors worry that the quickening pace of the Fed’s pullback could become too much for markets to bear, undermining the safety and reliability of the Treasury market.”
The Biggest Worry
According to the Times, what market watchers are most worried about as the Fed’s balance sheet shrinks is liquidity. Since June 2021, the Fed has been letting a small number of bonds mature without being replaced. Starting this month, the Fed will allow up to $60 billion of Treasuries and $35 billion of mortgage bonds to roll off its balance sheet as the debts come due, twice as much as the past three months, the Times explained.
“As the Fed backs away, it’s not clear who will fill the void,” the analysis noted. “And even if new buyers for bonds can be found, the reduction in demand caused by the Fed’s exit is raising fears among traders of volatility that could make future market disturbances worse.”
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