At the center of Washington’s efforts to manage the US debt are the sales of new Treasury bills. For everyone involved, these are ideally little-noticed events.
But low demand for some recent auctions is raising concerns about the government’s ability to finance its growing debt in the coming years, with higher interest rates and record debt levels on the horizon for the foreseeable future.
Any serious problems likely won’t arise for some time, with multiple offers often still on the table for each bond the Treasury wants to sell. But the question of precisely why this current volatility is occurring complicates the debate over what reforms might be needed in the years to come.
Part of the answer clearly lies in a supply and demand problem, in the form of a flood of new Treasuries ($20.8 trillion in emissions so far in 2023) enters a more unstable market.
The main reason for weak demand is that traditional bond buyers appear increasingly inclined to look elsewhere for security guarantees following the a series of downgrades in the solvency of the United States. The aggressive tightening of monetary policy that has pushed interest rates to their highest level in 22 years is also opening up new opportunities for investors to find higher returns elsewhere.
But beyond current market forces, there is a growing debate about the structure of the bond market itself and whether the “plumbing” of how the U.S. government runs its books is up to snuff. . The question is whether the conjunction of all these factors could lead to economically disastrous auction failures in the years to come.
“It’s a question of national economic security,” says Stanford professor Darrell Duffie. including research on dealer balance sheets highlights the potential for a decline in “Treasury market functionality” in coming years.
His work – complete with a presentation this summer, at the Jackson Hole symposium — caught the attention of Washington officials because it likened the problem to a long-delayed but deeply needed public works project.
“It’s the method by which the government finances itself,” he emphasized in a recent interview. “And if you don’t fix it quickly, you’re setting yourself up for disaster.”
“All the characteristics of a problem”
On the Treasury side, Janet Yellen and her aides have been monitoring mechanical issues but downplaying any connection between existing structural issues and 2023 volatility.
“It is worth emphasizing once again that recent increases in term premiums and volatility do not appear to be due to technical issues in the functioning of the market; but rather to liquidity conditions which have held up well,” said Nellie Liang, Treasury Undersecretary for Domestic Finance. told a room full of market participants last month at the 2023 Treasury Market Conference.
The administration also launched an interagency working group to monitor the functioning of the Treasury market, regularly bringing together senior officials from the Treasury, the Federal Reserve, the Securities and Exchange Commission and others.
This group, a Treasury official told Yahoo Finance, is focused on “efforts to build resilience in this critically important market, on a large scale and long-term in nature.”
What all parties agree is that a further escalation in Treasury market volatility – whatever the underlying cause – could be felt throughout the economy.
Mark Zandi, chief economist at Moody’s Analytics, says these scenarios quickly become scary and could “quickly engulf the stock market, mortgage rates and loan rates, and that could have much bigger and broader implications.”
He notes that some current signals have “all the hallmarks of a problem,” likening the current situation to a yellow glow that could turn red if things continue without reforms.
A range of ideas for increasing stability
Treasury market stability has periodically come to the fore in recent years, including a COVID-era liquidity crisis known as a “cash rush” that required Fed intervention .
This time around, the SEC is currently in the process of proposing two changes to try to resolve at least some of the technical issues.
A push from the SEC, which was finalized this weekwould push more bond transactions to so-called central clearing platforms.
According to their advocates, these platforms make markets safer because of the additional support they impose on transactions between market makers.
Commissioner Jaime Lizárraga welcomed the changes in a statement, emphasizing that they would “help prevent market disruptions, reduce the need for Federal Reserve interventions, and strengthen market confidence.”
Duffie welcomes the changes to central clearing platforms as a key step forward, but warns that they “alone will not solve the problem”.
Another idea under consideration is a proposed rule aimed largely at hedge funds which play an increasingly important role in bond markets. This change would require some firms to register as broker-dealers and be subject to stricter capital and liquidity requirements if they wish to continue playing in the market. It was first offered in March.
In a new letter Published Friday, Senate Banking Committee Ranking Member Tim Scott (R-S.C.) raised concerns that the reforms could exacerbate plumbing problems and prompt some to exit the Treasury markets altogether.
“A decrease in the number of participants in the Treasury markets will also result in a potentially dangerous reduction in liquidity in these markets,” he wrote.
This rule is still debated and should be refined in the coming months to respond to Concerns on Wall Street on which companies exactly will be subject to the new requirements.
The question is whether a broad range of market participants would be subject to the new requirements or whether they could be more targeted to a small group of companies that act as large-scale liquidity providers but are not currently subject to these provisions.
A focus on transparency
A broader problem — outside experts and Treasury officials agree — is transparency in bond markets.
Transparency comes up often among experts, with Zandi citing market opacity as a structural risk. “If something goes wrong (you could see a rapid succession of failures) and that only happens in opaque and non-transparent markets,” he says.
Treasury officials have often emphasized transparency as a priority and are moving toward incremental market changes. “We have been making steady progress on this path,” Liang said recently, citing a policy change this year from weekly to daily reporting on items such as the number of secondary market trades and average prices.
THE recent change marks a notable improvement in transparency with more granular public release of secondary market trading data possible in the coming months following a review process.
Professor Duffie believes that even stronger measures may be necessary, particularly in terms of price transparency.
The current system could discourage traders, he says, because buyers must rely on resellers to get price offers without any point of comparison.
“You might end up not trading as much as you would if you could see the prices,” he says, calling such a move “another positive for market liquidity.”
As for additional changes to the system, Liang told market participants in October that “we will consider possible next steps for more transparency” after studying the effects of the current changes.
Either way, this plumbing problem will likely only grow in importance in the months to come.
“It’s suddenly showing up a lot more on our radar than before,” Maya MacGuineas, chair of the Committee for a Responsible Federal Budget, said in a recent interview, highlighting concerns that small shakes in this area could quickly escalate.
She adds that “changes could happen very suddenly, so I’m staying on the edge of my seat like I never have before about how the Treasury issuance is going to play out.”
Ben Werschkul is Yahoo Finance’s Washington correspondent.
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