Not long ago, as the Federal Reserve accelerated the pace of interest rate hikes and began to shrink its balance sheet, the global capital market became turbulent. In the process, not only major currencies such as the Chinese yuan, the Japanese yen, the euro, and the British pound were impacted, affecting the asset value of the relevant currencies, but the U.S. Treasury bond market itself was also in turmoil. The yield on 10-year U.S. Treasury bonds, an important pricing indicator, also rose sharply, rising above 4.25% for the first time since 2008 on October 21. On October 24, U.S. Treasuries retreated to erase gains, and the yield on the 10-year Treasury note was adjusted to 4.22%. While market interest rates are on the rise, global capital is being adjusted according to the Fed’s measures.
U.S. Treasury Secretary Janet Yellen has recently spoken twice about risks in the U.S. Treasury market and stressed the need to strengthen its resilience. “To date, the US financial system has not been a source of economic instability,” Yellen said in her speech at the annual meeting of the Securities Industry and Financial Markets Association. “While we continue to watch for emerging risks, our system remains resilient and continues to operate well through uncertainties”. Earlier, Yellen also said in a speech in the middle of this month, “we are worried about a loss of adequate liquidity in the market”.
Media reported that Yellen is concerned about the operation of this USD 23.7 trillion market, mainly because the U.S. Treasury bond market is facing more and more large buyers leaving, liquidity decline, and higher volatility. As the Fed raises interest rates and begins to shrink its balance sheet, as a major buyer of Treasury and quasi-government bonds, the Fed is scaling back its purchases while major central banks are selling Treasuries to replenish dollar liquidity. At the same time, emerging market central banks are said to have sold nearly USD 300 billion in U.S. Treasuries in exchange for dollar liquidity so far this year, in the process of defending their exchange rate stability. In addition to the central banks, some sovereign investment institutions, as well as large financial institutions such as insurance companies and banks, also had to reduce their holdings of U.S. debt and rebuild the structure of assets and liabilities. JPMorgan strategist Jay Barry also points out that over the past decade, while one or two major buyers of U.S. Treasuries seem to back down, others have been there to fill the void, but this has not been the case recently. As the Fed tightens monetary policy and financial conditions, the demand for U.S. commercial banks for U.S. debt has also dissipated.
The departure of large buyers has caused a further imbalance between the supply and demand of U.S. Treasuries and a decline in market prices. The U.S. Treasuries saw the biggest fall this year since the early 1970s. The Bloomberg U.S. Treasury Total Returns Index is down about 13% so far this year, almost four times as much as it was in 2009. This was also its worst performance since the index was founded in 1973. According to data from the Department of Treasury on October 18, 2022, the U.S. 3-month Treasury yield was higher than the 10-year yield for the first time since before the outbreak of the COVID-19 pandemic. This is quite unusual. Researchers believe this could be one of the most obvious warning signs that after 6 to 18 months the American economy could experience recession. Another implication is that the U.S. 10-year Treasury yield may continue to soar, returning the yield curve to “normal”.
Changes in the U.S. Treasury market are closely related to the Fed’s monetary policy. Many market participants fear that excessive Fed policy tightening will lead to its collapse. Bank of America strategist Mark Cabana agrees that the collapse of the U.S. Treasury bond has become a tail risk that is accumulating. “We believe the UST market is fragile and potentially one shock away from functioning challenges” arising from either “large scale forced selling or an external surprise”, said Cabana. The next risk, he said, could come from a wave of mutual fund redemptions, the unwinding of hedge fund positions, and the deleveraging of risk parity strategies designed to help investors diversify assets. Under the Fed’s determination to continue the tightening policy of reducing its balance sheet, the Fed may face a similar situation that the Bank of England encountered not long ago and will have to temporarily buy bonds to avoid a liquidity crisis.
At present, in the context of global monetary policy tightening, troubles are brewing for the liquidity of Japanese and British government bonds. Under the policy of yield curve control, there has been a phenomenon where the bonds are not bought, but under the quantitative easing policy, the Japanese central bank can continue to buy Japanese government bonds in unlimited quantities to maintain prices. Unlike the Bank of Japan’s insistence on easing policy “bottoming” on Japanese government bonds, the Bank of England has begun to raise interest rates and reduce its balance sheet, which has increased the volatility of UK government bond prices, leading to the extreme of a market crisis.
Faced with the threat of high inflation and recession, the UK gilt and foreign exchange markets increased from early August to the close of October 11, with the yield on 10-year bonds rising from 1.84% to 4.64% at the closing price, and the pound depreciating 9.5% against the USD from 1.23 to 1.11. In particular, between September 21 and September 27, the ten-year British bond rose by 113BP from 3.40% to 4.53%, and the pound depreciated by 5.7% against the US dollar from 1.14 to 1.07. As a result, the UK pension has to sell its assets, leading to a vicious circle. The trigger for this problem is the previous stimulus plan of the Truss government, which needs to increase the issuance of British gilts, and the Bank of England, which was the main force of bond purchases, is promoting the reduction of the balance sheet under the tightening policy, thus making the British gilt to face the embarrassing market situation of few people showing interest in it. The turmoil in the UK financial market eventually led to the resignation of Liz Truss as the Prime Minister, and the Bank of England had to initiate temporary measures to temporarily stabilize the market.
The UK’s situation has piled up tremendous pressure on U.S. Treasury Secretary Janet Yellen. If the U.S. Treasuries cannot find a stable and sufficient alternative to the Fed, then its market risks cannot be ruled out. These circumstances show that Yellen’s worries are not unfounded. In fact, the effect of the Fed’s monetary policy has begun to roll in from the blow to overseas capital, hurting the liquidity of the U.S. Treasury market. If the Fed continues to adhere to its intense measures of raising interest rates and shrinking its balance sheet, and likely to be the final straw. The anchor price role of the U.S. Treasury bond market in the global capital market means that U.S. debt volatility will spread to the world, triggering a new round of sovereign debt crisis. When this happens, it would signify that the Fed’s policy shift is imminent.
The consequences of the withdrawal of large-scale quantitative easing have been shown in the UK, causing the spread of liquidity risks and market turmoil in the country’s gilt bonds. In the context of the Federal Reserve’s tightening policy, the tendency to increase liquidity risks is emerging in the U.S. Treasury market. The sovereign debt crisis that U.S. fiscal officials feared is not far off.
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