Recent headlines have touted the Bank of Japan (BoJ) and Japanese insurers selling Treasuries – in addition to the Fed’s slow unwinding of its quantitative easing (QE) purchases – and worried about a shortage. of buyers drying up liquidity in the critical US Treasury market.[i] Some claim that this risks a crisis. But this is not the first time such concerns have arisen. And, as in the previous times when bond market liquidity fears surfaced, we think they retain relatively little water. Most of the time, we see the pessimism of disbelief at work here, not mounting financial distress.
It has long been feared that bond markets could become illiquid – when selling can have a negative effect on price, making it difficult to exit a position – at the most inopportune moment, driving up rates and precipitating a financial crisis. Just when you want to cash out your money, you can’t, at least not without a straight haircut. Evaporating demand and weak trading can cause bond prices – which move inversely to yields – to go haywire. When this happened in March 2020, it spurred Fed intervention. Or more recently across the pond, UK government bond the volatility caused the Bank of England to suddenly intervene.
Today, many argue that the terrain is changing. The Fed is no longer buying Treasuries and it is unwinding the portfolio it has amassed under its QE bond buying program as the assets mature. Meanwhile, the BoJ is selling its Treasury reserves to support the yen. Without big central bank buyers to “prop up” the Treasury market, supply (supposedly) begins to overwhelm demand, risking pushing yields higher and prices falling.
Potentially driving the situation to a head: if the BoJ steps away from monetary intervention and joins the rest of the world’s major central banks in raising rates. This in turn could make the traditional “carry trade” of Japanese investors – borrowing at low and low Japanese yen rates, converting the proceeds into dollars and buying higher-yielding Treasury bills for fun and profit – less fun and profitable. Ending this flow would (supposedly) be the nail in the coffin of global Treasury demand. Japanese insurers reducing their Treasury positions would be an early sign of this.
A little perspective, however, lessens the fear, in our opinion. Let’s do a little scaling to reduce it to size. Selling Japan – or other major international treasury holders who do – is nothing new. China and Russia, for example, have significantly reduced their exposure in recent years without any adverse consequences. Chinese outflows made Japan the largest foreign treasury holder with $1.2 trillion.[ii] But now even it is selling off, having reduced its holdings by $100 billion over the past year. 100 billion dollars, is it big? That may seem like it, but given the size of the Treasury market — $24.4 trillion — that’s a rounding error.[iii] Outflows from the Japanese Treasury are relatively small. Even in the unlikely event that he sold all of his holdings, just 4.9% of the total, that wouldn’t be huge.
Now, Japanese Treasury cuts have coincided with US rate hikes. But the flow of funds from Japan did not motivate them – for every seller there is a buyer. What matters is the price they are willing to part with and pay, respectively. In our view, this is driven primarily by inflation, inflation expectations and the magnitude of rate hikes – the main drivers of bond markets around the world. yesterday inflation report underscores this, as yields plunged on the news.
The same logic holds for the Fed’s $95 billion monthly runoff – $60 billion in Treasuries and $35 billion in mortgage-backed bonds. The Fed currently holds just over $8.1 trillion in total assets, down from its spring peak of around $8.4 trillion.[iv] Of this amount, $5.5 trillion is in treasury bills. That $60 billion liquidation rate means about 1% of its initial Treasury holdings leave the Fed’s balance sheet every month, a gradual start to a decline of more than seven years if fully terminated. This means that the stock of debt not held by the Fed or the federal government is increasing by about 0.3% per month. Not only is this pace chilling, but it’s pre-priced. The Fed telegraphed its intentions well in advance, and while that could always change (see March 2020), we have already seen this movie— without a Treasury market crisis.
In the meantime, consider: Daily Treasury transaction volume averaged $574 billion in October and $622 billion year-to-date.[v] More than half a trillion in turnover every day overwhelms the numbers that pundits worried about bond market liquidity talk about. Additionally, Treasury issuance (including new offerings to replace maturing bonds) has averaged over $1 trillion per month this year, and auctions have been consistently oversubscribed. Although they consisted mainly of treasury bills (short-term paper financing the government for a year or less), the demand for longer maturities was – more or less – strong.
Take Wednesday’s $35 billion 10-year Treasury issue, for example. The cover denounced an ‘ugly’ and ‘absolutely awful’ bid as it returned 4.14%, an increase of around 3 basis points (0.03 percentage points) from 4.11% before the sale.[vi] That’s when demand as measured by the bid-to-cover ratio – the number of offers received to those accepted – hit 2.23, the lowest since August 2019. (Illustration 1) Still, yields at 10 years closed the day at 4.12%.[vii] A slight dip in demand at one auction – or several – says little about the direction of returns. After all, the decline in bid-to-cover ratios of the 1990s did not prevent rates from falling over the decade. Ultimately, demand for new treasury bills is regularly double the amount available and still frequently above 1990s levels.
Exhibit 1: Treasury auctions consistently see bids greater than twice the amount being bid
Source: Treasury and FactSet, as of 10/11/2022. 10-year Treasury bid-to-cover ratio and yield, January 1994 – November 2022.
In other words, the bond market seems quite liquid to us. And that’s in a period where bonds have been in a bear market overall. Growing liquidity fears show that sentiment continues to seriously underestimate reality, a positive development for markets. Maybe, just maybe, as reality probably disproves the idea that Treasury liquidity is a huge risk now, people can overcome this longer-term fear.
[i] “Japan’s Diminishing Appetite for Treasuries Fuels Anxiety on Wall Street”, by Sam Goldfarb and Megumi Fujikawa, The Wall Street Journal, 08/11/2022. “Analysis: Ongoing US Treasury Liquidity Problems Add to Fed Balance Sheet Trouble,” Gertrude Chavez-Dreyfuss, Reuters, 08/11/2022. “Wall Street Alchemists Turbocharged Treasuries’ Wild Swings,” Justina Lee and Liz McCormick, Bloomberg08/11/2022.
[ii] Source: US Treasury, 09/11/2022. Main foreign holders of Treasury bills, August 2021 – August 2022.
[iii] Source: US Treasury, 09/11/2022.
[iv] Source: Federal Reserve Bank of New York, as of 11/09/2022. System open market account portfolio, 04/13/2022 – 11/02/2022.
[v] Source: Securities and Financial Markets Industry Association, 09/11/2022.
[vi] “The numb Treasury market takes an ugly 10-year auction in stride,” Elizabeth Stanton, Bloomberg, 09/11/2022. “Auction of $35 Billion in 10-Year U.S. Treasury Notes Was ‘Absolutely Horrifying,’ Says Bleakley’s Boockvar, Staff, MarketWatch09/11/2022.
[vii] Source: Treasury, 09/11/2022.