US bond market volatility hits fresh highs as liquidity drops

Turmoil in U.K. financial markets and global expectations for persistently high inflation have ignited the U.S. government bond market, throttling volatility to highs not seen since the early days of the pandemic.

On Sept. 28, the ICE BofAML MOVE Index, which tracks the price movements of options on a basket of Treasurys to measure volatility in the government bond market, settled at its highest point since March 2020. Back then, turmoil in the government bond market pushed the Federal Reserve to drop rates to 0% and launch a massive bond-buying program.

This time, volatility was spiked by the Bank of England's plan to buy £65 billion of bonds to calm a growing pensions sector crisis triggered by the new government plan to cut taxes and boost spending.

"I think the market was caught offsides that a [central bank] would ease with [quantitative easing] while tightening at the same time, especially with inflation so high," said John Luke Tyner, a fixed-income analyst at Aptus Capital Advisors. "The question is, who is next? Japan? Uncertainty is certainly key."

U.S. government bond yields have soared this year as the Fed has hiked rates by 300 basis points and plans to continue hiking into 2023 in its ongoing battle to curb the highest inflation in 40 years. Yields on shorter-term bonds have seen the most substantial increases — the six-month yield, for example, has jumped 368 basis points from the start of the year to its Sept. 28 settlement.

As yields have risen, inflation appears to have peaked, even though it remains well above the Fed's 2% target. The consumer price index, the market's preferred inflation metric, jumped 8.3% from August 2021 to August 2022, U.S. Bureau of Labor Statistics reported Sept. 13.

"There is a lot of uncertainty around forward inflation, and the distance between Treasury yields and inflation," said Lyn Alden, who runs an investment research service. "In other words, the right and left tails around the 'bell curve' for where Treasuries should be priced at are fatter than usual, due to economic issues that are more uncertain than usual."

Liquidity issues

With volatility high and the dollar strengthening to record heights, liquidity in the $23.7 trillion Treasury market is under severe pressure.

"Liquidity and volatility are two sides of the same coin in my view: low liquidity means greater volatility … and greater volatility leads to lower liquidity," said Antoine Bouvet, a senior rates strategist with ING.

As volatility increases, market participants are less likely to enter the market or become motivated to reduce their exposure. Fewer market participants means that each trade has the potential to move the market much more, Bouvet said.

The strength of the dollar has caused foreign reserve managers to, in some cases, pull back their exposure to U.S. government bonds in order to stabilize their own currencies, worsening liquidity, Alden said.

In addition, foreign exchange hedging costs are high, limiting purchases of U.S. Treasurys from foreign private pools of capital. And commercial banks are limiting their government bond purchases, partly due to supplementary leverage ratio regulations, Alden said.

"I think there will be periods of Treasury volatility and yields leveling off, but I view the Treasury market as likely to remain disorderly overall," Alden said.

The Fed has projected rate increases through at least 2023. Bond market volatility should ease and liquidity will improve once the Fed begins moving away from its aggressive monetary policy tightening.

Learn more about the news and research available on S&P Capital IQ Pro