Global Treasury market under pressure as Fed raises rates


The next Fed crisis is already being prepared. Unlike 2008, where “subprime mortgages” froze counterparty trading in credit markets when Lehman Brothers failed, in 2022 it could well be the $27 trillion Treasury market.

When historians look back on 2022, many will remember it as a year when nothing worked out. This is quite different from what people thought was the case.

Throughout the year, soaring interest rates, the Russian invasion of Ukraine, soaring energy costs, inflation at its highest level in 40 years and the mining of liquidity in stocks and bonds has violently shaken the markets. Since 1980, bonds have been the de facto hedge against risk. However, in 2022, bonds suffered the worst decline in over 100 years, with a 60/40 stock and bond portfolio returning a horrendous -34.4%

The decline in bonds is the most significant. The credit market is the “lifeblood” economy. Today more than ever, the functioning of the economy requires ever-increasing levels of debt. From corporations issuing debt for stock buybacks to consumer operations that leverage to maintain their standard of living. The government requires continued issuance of debt to finance spending programs, as it needs the full tax revenue to pay for social protection and debt interest.

For better perspective, more than $70 trillion in debt is currently needed to support the economy. Before 1982, the economy was growing faster than the debt.

Debt issuance is not a problem as long as interest rates remain low enough to support consumption and there is a “Buyer” for the debt.

A lack of marginal buyer

The problem arises when interest rates rise. Higher rates reduce the number of willing borrowers and debt buyers balk at lower prices. The latter is the most important. As debt buyers evaporate, the ability to issue debt to fund spending becomes increasingly problematic. This was recently pointed out by Treasury Secretary Janet Yellen.

“We fear a loss of adequate liquidity in the [bond] market.”

The problem is that outstanding Treasury debt has increased by $7 trillion since 2019. However, at the same time, major financial institutions that act as “primary dealers” do not want to serve as net buyers. One of the main reasons for this is that for the past decade, banks and brokerages had a willing buyer to whom they could offload treasury bills: The Federal Reserve.

Today, the Federal Reserve no longer acts as a willing buyer. Therefore, the primary dealers don’t want to buy because no other party wants the bonds. As a result, Treasury market liquidity continues to evaporate. Robert Burgess well summarized:

“The word ‘crisis’ is not hyperbole. Liquidity evaporates quickly. Volatility is skyrocketing. Once unthinkable, even demand at government debt auctions is becoming a concern. The conditions are so worrisome that Treasury Secretary Janet Yellen took the unusual step on Wednesday of expressing concern over a potential trading breakdown, saying after a speech in Washington that her department is “worried about a loss of adequate liquidity” in the $23.7 trillion market for the United States. state titles. Make no mistake, if the Treasury market crashes, the global economy and the financial system will have far bigger problems than high inflation.

It’s not the first time this has happened. Every time the Federal Reserve has previously raised rates, attempted to halt “quantitative easing” or both, a “crisis event” occurred. This required an immediate response from the Federal Reserve to provide a “accommodative policy”.

‘This all comes as Bloomberg News reports that the biggest and strongest buyers of Treasuries, from Japanese pensions and life insurers to foreign governments and US commercial banks, are all pulling out at once.’We need to find a new marginal buyer of Treasuries as central banks and banks as a whole exit the scene on the left. –Bloomberg

It’s no problem until something breaks

As stated earlier, although there are real “traffic signs” fragility of the financial markets, they are not enough to force the Federal Reserve to change its monetary policy. The Fed noted this in its recent meeting minutes.

“Several participants noted that, particularly in the current highly uncertain global economic and financial environment, it would be important to calibrate the pace of further policy tightening to mitigate the risk of significant adverse effects on the economic outlook.

Although the Fed is aware of the risk, history suggests that “crisis levels” necessary for a change in monetary policy remain distant.

Source: Bank of America

Unfortunately, history is riddled with monetary policy mistakes where the Federal Reserve tightened too much. As markets rebel against quantitative tightening, the Fed will eventually accept the selling deluge. The destruction of the “wealth effect” threatens the functioning of equity and credit markets. As I will discuss in a future article, we are already seeing the first cracks in the currency and treasury markets. However, volatility is reaching levels where “events” occurred.

As noted in “Inflation will become deflation” the main threat from the Fed remains an economic or credit crisis. The story is clear that current Fed actions are once again behind the curve. Every rate hike brings the Fed closer to the junk “Horizon of events”.

“What should concern the Fed and the Treasury Department most is the deterioration in demand at the U.S. debt auction. A key metric called the bid-to-cover ratio at the government’s bid on Wednesday $32 billion in 10-year benchmark bonds was more than one standard deviation below last year’s average, Bloomberg News.

When the lag effect of monetary policy collides with growing economic weakness, the Fed will realize its mistake.

A crisis in the Treasury market is probably much bigger than the Fed thinks. Therefore, according toat Bloomberg, there are already potential plans for the government to step in and buy back bonds.

“When we warned last week that Treasury buybacks could start entering the debt management conversation, we didn’t expect them to jump into the limelight so abruptly. September’s liquidity constraints may have heightened Treasury interest in buybacks, but it’s not just a knee-jerk response to recent market developments.

If something breaks in the Treasury market, it will probably be time to buy both stocks and long-term Treasuries like the next “Fed or Treasury put” Return.

By Lance Roberts via Zerohedge.com

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