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When traders in the $24 trillion US Treasury market have trouble trading, it’s a matter for far wider concern. Liquidity metrics are flashing at crisis levels, making the debt market that’s a key underpinning of global financial markets potentially so fragile that another shock could impair its functioning. That’s why for the first time in more than two decades, the Treasury is considering buying back its bonds as a way of stabilizing the situation and buying time for policy makers to find more permanent solutions.
1. What’s happening in the Treasury market?
Treasury liquidity metrics in September reached the worst levels since the market mayhem at the onset of the pandemic. The Bloomberg US Government Securities Liquidity Index — a gauge of deviations in yields from a fair value model — remains near the highest levels since March 2020, when a flight to cash prompted the Fed to begin buying securities to stabilize the market. Treasury Secretary Janet Yellen expressed concern in mid-October, noting that the balance-sheet capacity of broker-dealers to engage in Treasury market making hadn’t expanded in line with an increase in the overall supply of Treasuries. Treasury debt outstanding has climbed by about $7 trillion since the end of 2019, but big financial institutions haven’t been as willing to serve as market-makers.
2. What’s causing the problem?
A year of steep losses for bonds caused by rising inflation and Fed interest-rate increases has led many of the traditional big participants, like US commercial banks, foreign governments and life insurers, to shy away from the debt market. Big financial institutions haven’t been as willing to serve as market-makers, burdened by the so-called supplementary leverage ratio, or SLR, which requires that banks set aside capital against such activity. In addition, the Federal Reserve has begun cutting some of its holdings of Treasuries, a process known as quantitative tightening that many fear will make liquidity issues worse.
3. What is the Fed doing?
It’s currently offloading its Treasuries from its balance sheet at a pace of $60 billion a month. As the largest buyer of government debt, its decision to step back means that dealers are going to be expected to absorb the additional supply that’s returning to the market. That’s a job that will become increasingly difficult the longer the Fed’s balance sheet shrinkage goes.
4. What is Treasury thinking of doing?
It’s deciding whether it will buy back older securities and replace them with larger current issues in either Treasury bills, or notes and bonds, depending on the government’s objective.
5. Has it done this before?
The Treasury last conducted buyback operations between March 2000 and April 2002 to allow the department to continue to sell new bonds to maintain its market access at a time when the federal government was running a budget surplus and didn’t need the money. Funds raised by selling new bonds were used to repurchase old ones.
6. How would Treasury buybacks work?
That’s what it’s trying to figure out at the moment. In its quarterly survey released in connection with the financing to be announced Nov. 2, it asked the 25 primary dealers who are its conduit to the broader debt market for a detailed assessment of the merits and limitations of a buyback program. At this point the critical question for Wall Street strategists is whether the operations would be duration neutral. That means whatever government securities the Treasury buys back would be replaced with debt with the same maturity so as to keep the weighted average maturity of the outstanding debt — currently a record-high 74 months — virtually unchanged.
7. How would that improve Treasury market liquidity?
Buyback operations would offer an alternate buyer for less liquid, less desired off-the-run issues. Treasury could retire old, cheap securities and provide an outlet for dealers to improve their balance sheet management. Also, the signaling impact of an operation could help market functioning if conditions were to improve on announcements alone. For example, 20-year bonds, the segment of the market that’s seen to have the most to gain from a buyback program rallied after the survey was released.
8. When could this happen?
That’s too soon to say. Bank of America strategists predict Treasury could launch its program in May 2023, though they acknowledged that the timing could be sped up in the event of “intense Treasury market functioning issues.” After all, the systems are already in place to conduct such operations. However, Credit Suisse strategist Jonathan Cohn sees the first quarter of 2023 as the earliest launch date, depending on liquidity deterioration and dealer balance sheet constraints.
9. Is there anything else that can be done improve market functioning?
For starters, the Fed could adjust the terms of its standing repo facility — where banks can park their Treasuries overnight in exchange for cash — to make Treasuries more attractive to hold. The Securities and Exchange Commission is proposing moving more Treasuries trading activity to existing clearinghouses — which sit between buyers and sellers and ultimately backstop transactions — in an effort to protect against market meltdowns. Market participants are also hoping for other changes, such as the Fed exempting Treasuries from the supplementary leverage ratio, which would give banks greater incentives to hold government debt, especially in lower volume environments. The Fed had waived Treasury and bank reserves from the SLR in March 2020 before letting the exemption expire the following year.
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