Friday, November 18, 2022

The Most Important Market In The World Is Creaking

The stock market gets the glory (incessant publicity), but the most important market in the world is the bond market, particularly US Treasurys. Everything, and I do mean everything, is ultimately based on it. It hasn’t always been so, but ever since the abolition of the gold standard in 1970’s, and more recently the emergence of shadow banking and the effective abolition of bank reserve requirements has led to an explosion of debt. 

Yes… Sudden Debt…

Obviously, the proper functioning of the US Treasury market is of paramount importance: liquidity, breadth, depth, transparency and regulatory oversight are the cornerstones of any market and are taken for granted for Treasurys.  Lately, however, something is seriously wrong as the chart from a very important FT article shows.

Liquidity, measured as the amount of a single trade that can be executed without seriously moving the market up or down,  has deteriorated to dangerous levels at the very time that the size of the market has quintupled. In 2010 liquidity stood at almost $800 million and today at just $100 million.  As a ratio of the total market, liquidity has collapsed 97.50% from its 2010 levels. Another way to look at it: for a bond trader it is now 42 TIMES more difficult to execute trades in US Treasuries - in equivalent market size. 

In practical every day terms it's not as bad as that because a chunk of Treasuries sit at the Fed's balance sheet, around $5.5 trillion worth. Still, it's bad enough.  Furthermore, the Federal Reserve Bank is ultimately... a bank!  At the end, it too has to take into account how heavily exposed it is to its borrowers and how liquid is its portfolio.

As a bond market professional, this liquidity plunge is really scary.  It could create enormous price volatility in the market, a possible repeat of what we saw in UK gilts recently, but magnified many times over.  If it happens, it would necessitate the massive intervention of the Fed in the form of another QE, at a time when we need the exact opposite (QT).to tame inflation. 


  1. let me try and summarise the article:

    The U.S. interest rate is currently too low to attract many bond buyers; come on guys, -6%,... really??

    If the Fed wants to keep interest rates at current levels and the U.S. govt wants to run a budget deficit (and thus have to issue new bonds), then the Fed will have to buy those bonds... which creates even more inflation...

    1. Japanese bond market barely trades for the same reason. Sooner or later, nobody will buy these IOUs voluntarily.

    2. I agree with krugman on this... with the cavet that we use the word real interest rate everywhere he says interest rate...

  2. Low liquidity is never much of a problem when prices are rising, nobody complains about making a lot of money from higher prices. But on the way down, things can get really ugly.

    Low liquidity right now means there are no large long term fundamental buyers for Treasuries out there. No foreigners, no pension funds, no insurance companies, no banks. The Fed’s own o/n reverse repo has ballooned to 2.2 trillion - unprecedented - another sign that institutions are not willing to buy bonds.

    Fewer bond buyers = greater difficulty of funding the budget deficit, so the Treasury needs to pay higher rates on its bonds. But with debt/GDP also at historic highs debt service becomes a serious problem, sooner rather than later, creating a classic debt death spiral.

    The bond market is flashing red warning lights:

    The Fed has no choice: it must kill inflation NOW.
    The Treasury has no choice: it must slash the budget deficit NOW.

    If not, be prepared for the unthinkable.

    PS one possible positive from the Republicans gaining the House: they may vote against a debt ceiling increase this time.


  3. I guess the question in my mind, and I suspect that of your other readers, is how you rate the risk of catastrophe.

    i.e. are we talking about near certain catastrophe if the current U.S. trajectory is maintained; or are we talking about seriously amplified risk, that may or may not come to pass.

    1. I think the risk of a US default or a credit event is higher than that implied by its AAA rating. If rating agencies were truly objective I think an A+ rating would be nearer to the truth.

    2. that is a very precise answer! thanks man. =)

  4. Would you elaborate the "unthinkable" event(s)? I know they are "pure speculations" or "conspiracy theories".

    1. By H.

      In order from less to most unthinkable:

      A failed Treasury bond auction, forcing the Treasury to cancel it. This would happen due to lack of buyers and/or bids much lower than current rates.

      A massive Fed intervention in the secondary bond market as buyer of last resort to support plunging prices. (The BOE did it recently).

      A credit event caused by, say, failure of Congress to raise the debt limit. Such an event could be the inability of the Treasury to pay the interest and/or principal of a maturing bond in a timely manner because it cannot refinance by selling new bonds.

      Monetization of debt on a regular basis by the Fed causing runaway inflation.

      US Bankruptcy.

    2. Thanks for the reply. I personally don't think these are "conspiracies" at all. The US abandoned the gold standard decades ago. Perhaps it will abandon the fiat currency and replace it with a digital one. (The transition will happen in some distant future regardless.)

    3. By H.
      No these are certainly not conspiracies, this blog deals in realities and possibilities, even if remote.

      As for digital currencies: there is absolutely no difference between a fiat currency and a digital one, if the issuer is a central bank or other government body. Except for one: paper currency is a bearer instrument and thus untraceable, for the most part. A digital currency is 100% traceable. And, btw, so are all “crypto” currencies, ultimately.