Can the Fed Fix the Treasury Market?

By Maura T. Murphy, CFA, Alpha Strategies Portfolio Manager and Michael Gladchun, Director of US Rates Trading

Update: As of 5pm EST on Sunday, March 15, the Federal Reserve cut the target range for the fed funds rate to 0.00% – 0.25% and announced a formal quantitative easing program, in line with our thesis. The post below offers background on our thinking. 

When the world’s biggest debt market starts having major liquidity issues, investor panic rises to a whole new level.

On March 12 and 13, after about a week of extraordinary dysfunction in the US Treasury market, the Federal Reserve issued a major crisis response, expanding Treasury purchases and repurchase operations to boost liquidity and shore up so-called risk-free assets.

Will it be enough to fix the Treasury market? Here’s our take.

It’s a big deal

Effectively, the Fed just kicked off quantitative easing lite. The March 12 announcement laid out a month-long, $60 billion bond-buying schedule that included Treasurys of all maturities. On March 13, the Fed accelerated that schedule and bought $37 billion of bonds across the curve. (The original purchase schedule called for $15 billion worth of relatively short-duration securities on March 13.)   

This is a big deal. First, the announcement to buy across maturities was a surprise. Many Fed-watchers had only expected purchases to eventually expand out to the 2-year part of the curve. Second, by taking two aggressive actions before the March 17-18 Federal Open Market Committee meeting, the Fed is signaling that it will not let liquidity dry up and that it is committed to stabilizing markets. It’s also the second time this month that the central bank has taken emergency action outside the regular meeting calendar (the first being the March 3 intermeeting rate cut).

Will it be enough?

Initially, the market didn’t seem to think so.

On March 12, even after massive intervention, Treasury volatility remained unusually high. We saw intraday swings as large as 20 basis points on the 10-year Treasury yield, way outside the norm. Yields on every key rate from the 7-year to the 30-year bond actually closed higher on Thursday after the Fed’s initial purchase announcement. Friday again brought large swings in cash bond trading, with roughly 40 basis points of intraday yield moves on the 10-year Treasury. Liquidity pressure continues. The Chicago Board Options Exchange is temporarily closing its trading floor starting Monday, March 16, which could further impact liquidity in the Treasury futures market.

What’s going on?

Right now, the Treasury market is not functioning normally. High-frequency trading (HFT) has provided most of the liquidity in the Treasury market in recent years. HFT was a major player that helped maintain a semblance of normalcy and liquidity as yields plunged to record lows. But now HFT is sidelined because the inputs that it needs to function (like tight bid/offer spreads, sufficient market depth and stable correlations) are out of whack. Human traders are back at the helm, only there are far fewer of them than before the financial crisis. Meanwhile, the Treasury market is roughly three times larger today.

The dramatic decline in Treasury market liquidity is apparent in wider bid/offer spreads and the lack of depth underlying those quoted prices. We estimate that for the most liquid “on-the-run”[1] Treasury securities, the quantity of bonds that can be traded at the quoted price is about 10% of normal. Liquidity conditions have deteriorated even further for less liquid “off-the-run”[2] Treasury and Treasury inflation-protected securities.

The fix isn’t in…yet

The Fed is trying, but the market has signaled that it needs more support. The good news is that this Fed has shown again and again that it will deliver what the market requires.

These recent actions further the Fed’s commitment to address disruptions in the Treasury market. We welcome this necessary, quick reaction. We believe the Fed will overdeliver with 100 basis points of easing next week and a formal quantitative easing announcement.

[1] On-the-run Treasurys are the most recently issued US Treasury bonds or notes of a particular maturity.

[2] Off-the-run Treasurys are securities that have been issued before the most recent issue and are still outstanding.

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