The deepest, most liquid bond market in the world is in big, big trouble.
For months, traders, academics and other analysts have feared that the $23.7 trillion Treasury market could be the source of the next financial crisis. Then, last week, US Treasury Secretary Janet Yellen acknowledged concerns about a potential collapse in Treasury trading, expressing concerns about “a loss of adequate liquidity in the market”. Now, strategists at BofA Securities have identified a list of reasons why U.S. Treasuries are at risk of “a large-scale forced sale or an external surprise” at a time when the bond market needs a reliable group of large buyers.
“We believe the UST market is fragile and may be just a shock away from working challenges” resulting from either “large-scale forced sales or an external surprise,” said BofA strategists Mark Cabana, Ralph Axel and Adarsh sinha “A UST default is not our base case, but it is a build-up tail risk.”
In a note released Thursday, they said “we’re not sure where this forced sale might come from,” although they have a few ideas. The analysts said they see risks arising from mutual fund outflows, hedge fund unwinding of positions and deleveraging from risk parity strategies put in place to help investors diversify risk across assets.
Events that may surprise bond investors also include acute year-end funding stress; a democratic turnaround in the midterm elections that is not widely expected at this time; and even a change in the Bank of Japan’s yield curve control policy, according to BofA strategists.
The BOJ’s yield curve control policy, which aims to keep the country’s 10-year government bond yield around zero, is being pushed to a breaking point on rising global interest rates and yields. As a result, some expect the BOJ to adjust policies introduced in 2016 and seen as increasingly inconsistent with other central banks.
Read: Here’s what’s at stake for markets as the Bank of Japan remains dovish
Investors are currently grappling with a cauldron of risks: continued inflation in the US and globally, accompanied by continued rate hikes by the Federal Reserve and other central banks, and continued uncertainty about where the global economy and financial markets are headed. US officials are so concerned about the possibility of a repeat of the September volatility that gripped the UK bond market that Fed and White House officials reportedly asked investors and economists last week if a similar meltdown could occur here, according to the New York Times.
Illiquidity in the normally smoothly functioning Treasury market means that government bonds cannot be bought and sold easily and quickly without significantly affecting the underlying price of bonds – and this type of situation would theoretically create problems for almost any other asset class.
Traders are just beginning to discount a greater likelihood that the Fed Funds rate target could climb above 5% next year from current levels of between 3% and 3.25%, raising the likelihood of further bond sell-offs not long after Investors’ conclusion raises their heads to a 4% level for interest rates.
On Thursday, Treasury yields continued to rise, sending 2-TMUBMUSD02Y, 4.618%, 10-TMUBMUSD10Y, 4.237% and 30-year yield TMUBMUSD30Y, 4.233% further to multi-year highs. Meanwhile, all three major US stock indexes DJIA, -0.30% SPX, -0.80% COMP, -1.00% were lower in the last hour of trading.