Tuesday, July 5, 2022
The U.S. Treasury market is arguably the most important market in the world. Not only does the market provide the financing of the federal government, it also provides a safe and liquid asset to support the flow of capital and credit to households and businesses, and also facilitates the implementation of monetary policy. With Fed tightening taking place at an elevated pace and market participants positioned for still higher rates, intra-day price moves in the Treasury market have been outsized with double-digit moves becoming the norm rather than the exception. While some of those day-to-day price moves could be technical in nature, likely playing a role is the lack of liquidity in the Treasury market over the past 12-months.
“Treasury market stability is an important part of the Fed’s job,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “And if the Fed’s job wasn’t hard enough, the worst case scenario is that liquidity doesn’t improve and the Fed has to slow the shrinking of its balance sheet just as it gets started.”
As seen in the LPL Chart of the Day, liquidity in the Treasury market, as measured by the Bloomberg U.S. Government securities index, has been deteriorating with liquidity conditions as poor as they’ve been since the COVID-induced market volatility in 2020. Other metrics such as the spread between new and older issued Treasury securities (called on-the-run versus off-the-run securities) as well as the price action in the short-term funding markets further confirm the lack of depth in the Treasury market. Back in 2020, due to poor liquidity conditions in markets, the Fed had to step in to help stabilize markets. Now, the Fed is actively reducing liquidity to help tighten financial conditions in an effort to reduce consumer price pressures. Additionally, the Fed has just started paring back the amount it reinvests in Treasury securities. As such, the relative lack of liquidity in markets has been a big reason we continue to see elevated levels of volatility in fixed income markets broadly.
So what’s next? Unfortunately, until inflationary pressures show definitive signs of cooling so the Fed can slow rate hikes, we’re unlikely to see liquidity conditions improve. Also complicating matters is the continued withdrawal of liquidity by the Fed, which owns nearly 25% of Treasury securities outstanding. As it starts to play a smaller role in the Treasury market, other investors will need to step in to help support the market. However, if volatility and illiquidity pressures remain high, we may need to see higher yields in order to entice other investors to take on these additional risks in the normally staid Treasury market. In the meantime, investors should brace themselves for elevated levels of volatility in fixed income markets.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.