It's getting quiet in the Treasuries market.
U.S. government-debt trading at Wall Street's biggest banks has fallen 8 percent since the end of October from the comparable period last year, according to Federal Reserve data. It's down for the year, too, even with an unprecedented one-day surge in activity on Oct. 15.
While slow markets have pretty much always been bad for banks because they usually profit from more trading, the implications may be far greater this time.
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"If you get a little bit of selling, and it all comes at the same time, it's very possible you'll see a lot of volatility," Ira Jersey, head of U.S. interest-rate strategy at Credit Suisse Group AG said in a Dec. 4 Bloomberg Television interview. "Dealers won't be able to do their market-making function and you'll wind up seeing very large price moves."
Activity has waned in part because the Fed has been stockpiling Treasuries, swelling its balance sheet to a record US$4.5 trillion from $906 billion in September 2008. That's taken a significant proportion of the debt out of circulation.
Another reason: In response to new risk-curbing rules, bond dealers are reducing the inventories they use to opportunistically buy and sell debt.
Cutting Holdings
The biggest banks have slashed their fixed-income, currency, and commodities trading assets by more than $600 billion, or 30 percent, since the 2009 peak, Credit Suisse analysts estimated in a Dec. 4 report. Firms have reduced a measure called interest-rate value-at-risk by more than 70 percent in the period, according to the analysts.
This makes it challenging for investors to trade bigger blocks of government debt the way they used to—through banks' bond desks.
Less trading also means it's easier to push prices around. Volume has averaged $490 billion a day since Oct. 29 at the 22 primary dealers that trade directly with the Fed, compared with $531 billion in the comparable period in 2013, Fed data show.
The past two years have brought surprising swings in U.S. yields that roiled markets worldwide. There was the taper tantrum in May and June 2013 that led to a 3.2 percent loss for U.S. government bondholders. And then, on Oct. 15, benchmark yields plunged the most since 2009.
Meanwhile, tension is growing over which way the bond market's headed next year. While there's a groundswell of buyers rejecting the idea of meaningfully higher yields anytime soon, Wall Street analysts and some investors are predicting losses for debt as the Fed prepares to raise rates as soon as next year.
Someone is wrong. And there will probably be a eureka moment next year when the Fed's course of action becomes clearer. The less trading there is, the more painful that moment could be.
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