Declining liquidity in the US Treasury market represents the biggest systemic risk to financial markets, according to Bank of America.
The risk of falling liquidity and resiliency of US Treasuries could be bigger than the 2007 housing bubble, BofA said.
“While this sounds like a bad science-fiction movie, it is unfortunately a real threat,” BofA said.
Declining liquidity in the US Treasuries market represents the biggest systemic risk to financial markets since the 2007 housing bubble, if not bigger.
That’s according to a Wednesday note from Bank of America, which outlined just how important the day-to-day functioning of the US Treasury market is, and how imperative it is that the market functions without hiccups.
“The US Treasury market is the single most important financial market in the world, as Treasury rates are a fundamental benchmark for pricing virtually all other financial assets,” the G30 said in a July 2021 report, adding that confidence in the US Treasury market is essential for the stability of the global financial system.
But a problem is brewing in the US Treasury market, as the aggregate amount of capital allocated to market-making has not kept pace with the very rapid growth of marketable Treasury debt outstanding. As trading in the US Treasury market decreases, while the issuance of US Treasuries increases, a period of illiquidity could materialize.
“If the Treasury market fails to trade for a period of time, it is likely that the various credit channels including corporate, household and government borrowing in securities and loans would cease. This could lead to events such as a US government default if auctions do not proceed… It is hard to conceive of the spillover impacts to the dollar, equity markets, emerging markets, consumer and business confidence,” BofA said.
The spillover effects would be massive if it amounts to anything more than the bursting of the 2007 housing bubble, which led to widespread job losses, foreclosures, and deep global financial losses as liquidity in the housing market plummeted.
“While this sounds like a bad science-fiction movie, it is unfortunately a real threat that has absorbed a large amount of people-hours over the past 10 years with very little output from regulators or lawmakers,” the bank added.
Concerns about liquidity in the Treasury market comes as the Federal Reserve begins to remove itself as a big buyer of fixed income securities. The central bank is increasing its monthly balance sheet roll-off to $95 billion in September. The central bank has about $9 trillion in assets on its balance sheet, consisting of both US Treasuries and mortgage-backed securities.
And while the Fed has stepped in to buy US Treasuries during periods of market stress, it’s a “tenuous long-term solution for the central bank to act as a buyer-of-last resort of the federal debt,” BofA said.
“It is not structurally sound for the US public debt to become increasingly reliant on Fed QE,” BofA said. “It is risky in our view to rely on the Fed alone to solve the problem of Treasury market liquidity, resilience and functioning.”
Instead, BofA believes a better long-term solution is for the creation of a dealer of last resort that is not the Federal Reserve, which is governed by its dual mandate of price stability and low unemployment.
“We believe such an entity should be formed before a crisis requires it. A dealer of last resort could make markets in a wide range of cash securities, futures, swaps, equities, bonds, foreign exchange, commodities, just like large international dealers do today,” BofA said, adding that it should be structured as a government sponsored enterprise.
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