Treasury Vol Awakens Market-Structure Concerns

Terry Flanagan

Recent volatility in U.S. Treasuries has renewed concerns about how the structure of the $14 trillion market would hold up amid a bigger storm.

The benchmark 10-year note increased about 50 basis points in the first six weeks of 2018, to 2.9% as of mid-February. It was a jolt from an extended period of calm, but still fairly modest on the scale of historical volatility. The question is, what would happen if the yield zoomed up something in the order of 25 basis points overnight and/or 60 ‘beeps’ in a week?

Such a dramatic move would be driven by a macro event, perhaps China cutting its holdings of Treasuries, or a higher-than-expected inflation report that portends a more hawkish Federal Reserve. That 30,000-feet-up story would be left to CIOs and portfolio managers to sort out — for traders, the practical consideration would be finding sufficient liquidity amid the selloff.

In 2017, the 10-year yield traded between 2.04% and 2.63%, the narrowest annual range since 1965, CNBC reported. The yield traded mostly between 1.7% and 2.7% for more than six years until very recently; there hasn’t been a true bear market in bonds since Fed-driven selloffs in 1999 and previously in 1994 — when Wall Street was the dominant liquidity provider. With the market structure changed since then, it’s unclear how a yield spike would manifest itself on the institutional trading desks of 2018.

“A real inflation scare, which we have not seen, could cause a spike in bond yield,” Fred Cannon, Director of Research at Keefe, Bruyette and Woods, said in a recent podcast. “As a result of the big banks scaling back the capital devoted to fixed income market making, it is possible that a lack of liquidity could create a rapid increase in bond yields.”

BlackRock noted the equilibrium of the Treasury market will be tested as interest rates rise. “Supply of Treasury bonds is headed up, and demand is declining,” Jeffrey Rosenberg, Chief Fixed Income Strategist at BlackRock Investment Institute, wrote in a Feb. 15 research note. “We estimate net supply could increase by some $488 billion, just as an erstwhile reliable buyer, the Federal Reserve, is trimming re-investments. This upsets the supply/demand balance of Treasury bonds.”

Alex Sedgwick

Alex Sedgwick. T. Rowe Price

The U.S. government debt market is one of the world’s most liquid, in aggregate, with a diverse global base of buyers and sellers. Accordingly, “it’s going to be more resilient than some other markets,” said Alex Sedgwick, Head of Fixed Income Market Structure and Electronic Trading at T. Rowe Price. “In many respects, adding a bit of volatility into a market can be beneficial, from the perspective of attracting interest from additional market participants.”

But when it comes to liquidity, not all Treasuries are created equal. While sellers of large blocks of the most recently issued 10-year note can expect to find a suitable bid even amid extreme volatility, that’s less assured for the government debt securities with thinner markets.

“Areas within Treasuries that tend to have lower liquidity than the on-the-runs are off-the-runs, and TIPS,” or Treasury Inflation-Protected Securities, Sedgwick said. “I wouldn’t necessarily describe them as pain points, but I would describe them as portions of the market that tend to have lower overall trading activity.”

One structural concern in the ‘govie’ market is that Wall Street has contracted over the past decade. There are fewer big banks, and the ones that remain generally are not covering all fixed-income bases as muscularly as they once did.

Josh Holden, OpenDoor

“There is a concentration of market share among Treasury dealers, certainly more now than what we used to have,” said Josh Holden, Chief Information Officer at OpenDoor Securities, which operates a bond-trading platform for off-the-run Treasuries and TIPS. “That is probably okay in the short term. But it is a systemic concern — as rates back up and volatility increases, the back-up buying from central banks and others that we’ve seen for a long time won’t be there, and might even turn to selling.”

Liquidity gaps in the off-the-run and TIPS markets have been masked by the prolonged period of low rates and low volatility, which “can cover up a lot because people aren’t trying to move really large positions,” Holden said.

In a situation where large buy-side institutions are selling Treasuries, “that’s kind of the scenario where you need to have alternate pools of liquidity, alternate ways of finding natural counterparties,” Holden continued. “I don’t think there is a single solution that’s going to solve volatility. But having many ways to transfer risk among many diverse market participants will help ameliorate the problem.”

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