The US Treasury market, long considered to be the deepest and most liquid market in the world, appears to be on shaky ground. This market is essential to the global financial system, but it has been showing signs of dysfunction and strains in recent years, with the US government running large deficits and foreign buyers of US Treasuries dwindling.
In recent months, there has been a noticeable increase in bond yields, with the US 10-year bond reaching nearly 5% in October, the highest level in 16 years. This surge in yields can be attributed to the Federal Reserve’s decision to increase interest rates, but the underlying issues in the Treasury market run deeper than just market fluctuations.
For decades, the sale of US Treasuries to foreign buyers has been a significant source of financing for the US government. However, since 2014, foreign central banks have stopped buying Treasury bonds on a net basis, signaling a significant shift in demand. One major reason for this shift is the realization that the US may no longer be able to manage the dollar in the best interest of the world. Additionally, in the wake of the 2008 financial crisis, the Federal Reserve implemented a quantitative easing program, which triggered concerns about the US’s ability to manage its currency responsibly.
The decline in foreign demand for US Treasuries has coincided with several instances of liquidity problems in the Treasury market. The market experienced convulsions in 2014, with what was dismissed as a “flash rally,” and subsequent disruptions in 2019 and 2022. Most notably, the market seized up in March 2022, coinciding with a significant spike in inflation and a sharp interest rate hike by the Fed.
In addition to the challenges posed by declining foreign demand and liquidity issues, many US banks found themselves underwater on their Treasury positions, resulting in large unrealized losses. This situation came to a head when the collapse of Silicon Valley Bank earlier this year revealed the extent of the problem. The widespread unease in the market prompted the Fed to take action, introducing a bailout program known as the Bank Term Funding Program (BTFP).
The BTFP allowed banks to access one-year loans from the Fed by posting bonds, effectively serving as a bailout for banks with considerable paper losses. However, the program’s approach to pricing collateral raised concerns, as it effectively propped up bond prices and capped yields, pointing to a broader trend of central bank intervention in the market.
Despite assurances that the banking crisis is over, the significant uptake of the BTFP by banks indicates ongoing vulnerabilities in the Treasury market. The implications of these developments are far-reaching, as they raise questions about the future stability of the global financial system. Recognizing these challenges, it is evident that addressing the fundamental issues in the US Treasury market is crucial to restoring confidence and stability in the financial system.