Treasuries liquidity problem exposes Fed to ‘biggest nightmare’

The latest bout of global financial volatility has heightened concerns about regulators’ continuing failure to resolve liquidity problems with US Treasuries -- the debt that serves as a benchmark for the world. It’s getting harder and harder to buy and sell Treasuries in large quantities without those trades moving the market. Market depth, as the measure is known, last Thursday hit the worst level since the throes of the Covid-19 crisis in the spring of 2020, when the Federal Reserve was forced into massive intervention. With rising risks of a global recession, escalating geopolitical tensions and the potential for further defaults by developing nations -- not to mention ructions in a developed economy such as the UK -- investors may not be able to rely on Treasuries as the reliable haven they once were.

“We have seen an appreciable and troubling deterioration in Treasury market liquidity,” said Krishna Guha, head of central bank strategy at Evercore ISI. Regulators “really haven’t delivered yet any substantial reforms,” he said. “What we are seeing at the moment is a reminder that the work is really important.” When the Treasuries market broke down amid a panicked rush into dollar cash in March 2020, the Fed swooped in as buyer of last resort. And while it now has a backstop facility allowing the exchange of Treasuries for cash, volatility, if extreme enough, could still force the Fed into action, observers said. That’s particularly awkward now, when policymakers are not only raising interest rates but actively shrinking the portfolio of Treasuries. So-called quantitative tightening is supposed to be playing an “important role” in tightening monetary policy, as part of the central bank’s battle to contain inflation. “The biggest nightmare for the Fed now is that they have to step in and buy debt,” said Priya Misra, global head of rates strategy at TD Securities. “If the Fed has to step in -- when it’s in conflict to monetary policy -- it really puts them in a bind,” she said. “That’s why I think regulators need to fix the market structure.” The Treasury Department is working on an initiative to enhance transparency in the trading of US government debt, seen as one step that could encourage dealers and investors to boost volumes. News on that front may come at a Nov. 16 annual market-structure conference.