(Bloomberg) - Like his Wall Street peers, Mark Cabana has had it with terrible trading conditions in the world’s largest bond market -- conditions that could worsen now that the Federal Reserve has just wrapped up its biggest asset-buying program in history.
In a Wednesday note titled “UST liquidity: sounding the alarm,” the head of U.S. interest-rates strategy at Bank of America Corp. stepped up his calls on policy makers to embark on a root-and-branch reform of the underlying marketplace for the world’s safest assets.
He warns that if Russia’s invasion of Ukraine continues to exacerbate longstanding liquidity woes, the Fed could be forced to delay plans to later this year begin allowing debt to roll off its balance sheet, known as quantitative tightening.
“We see rising odds of Fed action to support UST market functioning,” Cabana and colleagues wrote.
A Bloomberg measure of liquidity deteriorated this week to the weakest since the pandemic-spurred disruptions in 2020, in part because banks are less able to hold sufficient inventory of Treasuries, given regulatory constraints on their leverage.
That’s spurring strategists like Cabana to up their demands on the Treasury department to consider liquidity-boosting efforts like buying back older securities and cutting auction sizes in the least-traded corners of the yield curve.
Impaired Treasury functioning risks triggering global market volatility and can ultimately gum up the ability of the central bank to administer monetary policy. U.S. government debt yields are the benchmark used to help underpin valuations for an estimated $50 trillion in world assets.
“We continue to expect Treasury market functioning to remain somewhat challenged,” said Praveen Korapaty, chief rates strategist at Goldman Sachs Group Inc. in a note. “In the absence of the Fed’s ‘backstop’ presence, we believe it may take time and greater certainty in the geopolitical outlook for liquidity to materially improve, suggesting ongoing risk of somewhat disorderly yield swings.”
Fears over the micro-structure of the debt market are far from new. But geopolitical tensions and oncoming monetary tightening are raising the stakes.
Among Cabana’s calls on Fed actions:
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The Fed’s upcoming debt roll-off -- or at least the part of it related to Treasuries -- could be “delayed & pushed from May to June/July.”
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Replace mortgage debt that is rolling off its balance sheet with Treasuries
Lou Crandall, chief economist at Wrightson ICAP LLC, called on Treasury this week to consider buying back older notes and bonds, such as off-the-run securities that typically trade less frequently than newly issued debt.
Citigroup Inc. and Wells Fargo strategists have also issued fresh missives of late on declining bond liquidity in notes to clients.
“There continues to be no change in the (il)liquidity thematic,” of the Treasury market, Citi’s Edward Acton and William O’Donnell wrote in a note.
Rising volatility is unmasking deficiencies at the heart of the debt market. Yields have take a wild ride with the war triggering a flight-to-quality bid while the Fed’s upcoming tightening plan emboldens bears.
Benchmark 10-year yields have fallen from over 2%, just before the Feb. 24 Russian invasion of Ukraine, to as low as 1.67% on Monday. They traded on Thursday as high around 2.02%
(Adds Citigroup strategists comments.)
By Liz Capo McCormick
