The market for US Treasury securities is arguably the world’s most important: a haven for investors in turbulent times, and a benchmark for virtually all other assets. Yet it’s facing increasing strains, as the government’s unsustainable borrowing and the Federal Reserve’s quantitative tightening flood it with trillions of dollars of debt.
To ensure the Treasury market doesn’t become a source of instability, US authorities need to make some adjustments. Quickly.
Treasuries are popular in part because they’re typically extremely liquid, meaning they’re easy to buy and sell without causing big price swings. This feature depends, in part, on a small group of big banks, known as primary dealers, standing ready to trade and to hold large quantities of securities on their balance sheets. In recent years, though, the sheer volume of outstanding government debt, together with more stringent capital requirements, has rendered dealers less able to play their traditional role, particularly when there are sudden surges in activity and increased price volatility.
Other participants also now play a bigger role, and that has added to the fragility. Algorithmic trading firms provide illusory liquidity, holding securities for mere microseconds and withdrawing precisely at the volatile moments when their presence is most needed to make markets. Meanwhile, hedge funds employ vast leverage to exploit small discrepancies between Treasury prices in cash and futures markets. This “basis trade” makes the market more efficient, but also entails a big risk that, in volatile times, the funds will have to sell large quantities of Treasuries to meet collateral calls on their borrowings. Such forced selling could be destabilizing, given the size and concentration of the positions.
What to do? I see three ways to mitigate the risks.
First, someone with a highly expandable balance sheet must provide real, reliable liquidity. To that end, the Fed should allow all holders of Treasuries to access its standing repo facility, where it lends money against the collateral of government securities. This would allow hedge funds and others to raise cash quickly without needing to sell en masse. To ensure it would be used only as a backstop, the Fed should charge a slightly higher interest rate than what normally prevails in repo markets. Instead of trying to interact directly with the broader set of market participants, the Fed could employ primary dealers as agents, without burdening their balance sheets.