US Treasury market founders as liquidity dries up, volatility surges

Volatility and liquidity in the government bond market are near levels not seen since the early days of the pandemic.

U.S. Treasury bond yields are seeing substantial daily swings, banks and foreign investors are backing away from the market, and the Federal Reserve has wound down its monthly purchases of Treasurys and mortgage-backed securities.

As the Fed continues to hike rates and move toward tighter monetary policy, cracks are emerging in the nearly $23.9 trillion U.S. bond market. A persistent lack of liquidity and severe volatility could weaken the market, a foundation of the global financial system, and compel the Fed to shift away from the policy measures it has taken to limit runaway inflation.

"It's not a healthy-looking market at all," said Lyn Alden, an independent investment research provider. "The Fed is no longer buying, banks in aggregate are no longer buying and the foreign sector in aggregate is no longer buying."

Universal worries

The S&P U.S. Treasury Bond index, which measures the performance of the U.S. Treasury market, has fallen to its lowest level since 2010.

"Nothing's broken, but the market is very creaky," said Edward Al-Hussainy, a senior interest rates strategist with Columbia Threadneedle.

Overall liquidity in the market has deteriorated rapidly, with the Fed stepping away from bond purchases and hiking its benchmark federal funds rate and with Russia's invasion of Ukraine continuing to weigh on the global economy.

Uncertainty about the economic outlook, particularly as inflation continues at a pace not seen since the early 1980s, has triggered "an almost universal worry," about liquidity in the Treasury market, said Antoine Bouvet, a senior rates strategist with ING.

"Given the number of event risks, including a cutoff of gas flows from Russia to Europe, I think these fears are justified," Bouvet said.

'Crisis levels'

The decline in liquidity has also exacerbated volatility with the ICE BofAML Move Index — a bond market equivalent of the CBOE Volatility Index (VIX) "fear gauge" for equities — climbing to levels not seen since March 2020.

"We are hovering around crisis levels," said John Luke Tyner, a fixed-income analyst at Aptus Capital Advisors. "The bottom line is that liquidity isn't normal in the U.S. Treasury market."

The lack of liquidity and high volatility has pushed bond yields to move significantly each day as the Fed's interest rate raises have caused shorter duration yields above those of longer duration.

"Up until the beginning of this year people were kind of used to seeing 5-basis-point moves in the [10-year bond yield] in day," said Al-Hussainy with Columbia Threadneedle. "Now it's quite common to see 20-basis-point moves. If feels like volatility is exceptionally high."

Purchases of U.S. Treasurys by foreign investors have stalled as the dollar has surged to its highest levels in decades and remained there for months.

The Dow Jones FXCM Dollar Index on July 14 reached its highest point since 2002. The index measures the dollar's value against four currencies: the euro, the British pound, the Japanese yen and the Australian dollar.

The U.S. dollar's relative strength is also squeezing borrowers with dollar-denominated debts. As the dollar gets stronger, these borrowers need to sell Treasurys and other dollar-denominated assets in order to service those debts, Alden said.

"The strong dollar basically crunches foreign investors and forces them to trim U.S. assets," said Tyner.