Trading Treasuries keeps getting tougher and tougher.
For decades, the $12.5 trillion market for U.S. government debt was renowned for its "depth," Wall Street's way of talking about a market's ability to handle large trades without big moves in prices. But lately, that resiliency has practically vanished—and that's a big worry.
Less depth has meant greater volatility. So Treasuries—the world's haven asset during turmoil—may be prone to more disruptions, particularly as the Federal Reserve prepares to raise interest rates. And if investors begin to doubt whether they'll still be able to buy and sell on a moment's notice, that has the potential to elevate the U.S.'s cost to borrow.
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How much depth has the market lost? A year ago, you could trade about $280 million of Treasuries without causing prices to move, according to JPMorgan Chase & Co. Now, it's $80 million.
"It's something that we all have to deal with," James Sarni, a money manager at Payden & Rygel, which oversees $85 billion, said from Los Angeles. "There's a possibility that we may want to get out of things at a time when we can't get out."
The shift reflects the unintended consequences of new financial regulations, which have made bond dealers less willing to hold inventory and facilitate trades, as well as the Fed's debt purchases to shore up the economy.
The implications of a less-liquid Treasury market extend beyond Wall Street because it's the benchmark for governments, businesses and individuals when they borrow.
"The Treasury Department is constantly monitoring liquidity across all financial markets," spokesman Adam Hodge said in an email. "The Treasury market is the deepest and most-liquid market in the world and we are committed to ensuring that it remains that way."
Diminishing market depth and a surge in volatility were both on display Oct. 15, when Treasuries experienced the biggest yield fluctuations in a quarter century in the absence of any concrete news. The swings were so unusual that officials from the New York Fed met the next day to try and figure out what actually happened.
The Fed declined to comment on the risks of increasing volatility, according to spokeswoman Susan Stawick.
Bond Universe
Since then, the ability to trade Treasuries quickly and easily has shown few signs of improving. JPMorgan, one of the 22 primary dealers that trade with the Fed, estimates the amount of 10-year notes available to buy or sell at one time without moving prices has fallen more than 70 percent in the past year.
The measure is based on the average size of the best three bids and offers on ICAP Plc's BrokerTec trading platform during the U.S. morning. Liquidity is being squeezed as the precarious outlook for global growth has everyone piling into Treasuries.
"There aren't enough bonds on the planet to satisfy all the buying," said Charles Comiskey, the New York-based head of Treasury trading at Bank of Nova Scotia, a primary dealer.
Yields on 10-year notes have plunged a half-percentage point in the best start to a year since 1988 as consumer prices tumbled in Europe, China's economy showed signs of faltering and central banks around the world stepped up stimulus to head off the specter of deflation.
As Wall Street dealers offer fewer bonds at a given price to contend with the onslaught of demand, volatility has increased. Average intraday swings for Treasuries are the now most pronounced since October, data compiled by JPMorgan show.
They "haven't wanted to take the other side of trades," said Alex Roever, the Chicago-based head of U.S. interest-rate strategy at JPMorgan. "It's just part of the fabric of the market. Dealers are not able or willing to take as much risk, because of the position it puts them in."
New rules adopted after the credit crisis in 2008 to limit risk-taking are partly to blame, according to Roever.
Firms with bond trading desks have slashed inventories in response to regulations such as Basel III and the Volcker Rule. Primary dealers have reduced their U.S. debt holdings more than 80 percent to $24.5 billion from a record high in October 2013, data compiled by Bloomberg show.
New supply has also been constrained by central banks such as the Fed, which have stockpiled government bonds as part of their stimulus, adding $10 trillion to their balance sheets.
"The markets have been dramatically less liquid over the course of the last five years," said Elaine Stokes, who helps manage the $24.3 billion Loomis Sayles Bond Fund in Boston. Like many other funds, Stokes said her firm avoids "flipping in and out" of bonds and is instead holding onto the ones they buy.
As a result, only 4.1 percent of Treasuries changed hands each day last year, the least in records dating back to 1998, data compiled by Bloomberg show.
Not Broken
Although liquidity is a problem for many types of debt securities, there's little reason to think the Treasury market is broken, according to Peter Yi, director of short-term fixed income at Northern Trust Corp., which oversees $934 billion.
Primary dealers reported an average $500 billion a day in trades of Treasuries last year, about 3 percent below the average over the prior five years.
Price swings of Treasuries as measured by Bank of America Corp.'s MOVE Index are still far below levels before the financial crisis, even after surging more than 65 percent since August. Yields on 10-year Treasuries are approaching record lows and ended at 1.64 percent last week. They were at 1.71 percent as of 9:25 a.m. on Monday in New York.
"The Treasury market still remains the most-liquid market in the world," Yi said from Chicago. "We still feel pretty confident that you can sell out of Treasury securities."
That's OK when everyone wants to buy. But when the Fed starts raising rates, there's bound to be pain as investors rush to sell, said Bank of Nova Scotia's Comiskey.
He says bond buyers have become too complacent that yields will stay low and are ignoring signs the Fed is determined to boost borrowing costs as joblessness declines and the U.S. economy strengthens—even if inflation remains subdued.
While futures traders are betting the Fed will wait until December before raising rates from close to zero, St. Louis Fed President James Bullard said on Jan. 30 in New York that rates could increase as soon as midyear. Bullard said he also sees the potential for a bubble in government debt.
"If there's not concern, there ought to be," Comiskey said. "That's going to be the big shock."
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