The next financial crisis may already be brewing — but not where investors might expect
A growing number of traders, academics, and bond-market gurus are worried that the $24 trillion market for U.S. Treasury debt could be headed for a crisis as the Federal Reserve kicks its “quantitative tightening” into high gear this month.
How could the normally staid Treasury market become ground zero for another financial crisis? Well, Treasuries play a critical role in the international financial system, with their yields forming a benchmark for trillions of dollars of loans, including most mortgages. Waning liquidity has been an issue since before the Fed started allowing its massive nearly $9 trillion balance sheet to shrink in June. But this month, the pace of this unwind will accelerate to $95 billion a month — an unprecedented pace, according to a pair of Kansas City Fed economists who published a paper about these risks earlier this year.
“Since banks’ balance sheet space is lower than it was in 2017, it’s more likely that other market participants will have to step in,” Sengupta said during the call. In July, a team of interest-rate strategists at Barclays BARC discussed symptoms of thinning Treasury market in a report prepared for the bank’s clients.
Other measures of bond-market liquidity confirm the trend. For example, the ICE Bank of America Merrill Lynch MOVE Index, a popular gauge of implied bond-market volatility, was above 120 on Wednesday, a level signifying that options traders are bracing for more ructions ahead in the Treasury market. The gauge is similar to the CBOE Volatility Index, or “VIX”, the Wall Street “fear gauge” that measures expected volatility in equity markets.
Thinning liquidity has had the biggest impact along the short end of the Treasury curve — since short-dated Treasuries are typically more susceptible to Fed interest-rate hikes, as well as changes in the outlook for inflation. “We have had four or five days in recent months where the two-year Treasury has moved more than 20 [basis points] in a day. It’s certainly eye opening.”
Fleming, who still works at the Fed, didn’t respond to a request for comment. But interest-rate strategists at JP Morgan Chase & Co. JPM , Credit Suisse CS and TD Securities told MarketWatch that maintaining ample liquidity is just as important today — if not more so. As brokers pulled liquidity for fear of being saddled with losses, the Treasury market saw outsize moves that made seemingly little sense. Yields on Treasury bonds with similar maturities became entirely unhinged.
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