Liquidity in the US Treasury market represents the biggest systemic risk to stocks since the 2007 housing bubble, BofA says
- Declining liquidity in the US Treasury market represents the biggest systemic risk to financial markets, according to Bank of America.
- The downside risk to liquidity and resilience in US Treasuries could be greater than the 2007 housing bubble, BofA said.
- “Although it looks like a bad sci-fi movie, it’s unfortunately a real threat,” BofA said.
Declining liquidity in the U.S. Treasuries market represents the biggest systemic risk to financial markets since the housing bubble of 2007if not bigger.
This is according to a Wednesday note from Bank of America, which emphasized how important the day-to-day functioning of the US Treasury market is and how imperative it is for the market to operate smoothly.
“The U.S. Treasury market is the most important financial market in the world because 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, insofar as the aggregate amount of capital allocated to market making has not kept pace with the very rapid growth in the stock of negotiable Treasury debt. As trading in the US Treasury market declines, while the issuance of US Treasury bills 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 the auction does not continue… It is difficult to conceive of the repercussions on the dollar, stock markets, emerging markets, consumer and business confidence,” BofA said.
The fallout would be massive if it amounted to anything other than the bursting of the housing bubble of 2007, which led to widespread job losses, foreclosures and deep global financial losses as housing market liquidity plummeted.
“While it sounds like a bad sci-fi movie, unfortunately it is a real threat that has absorbed a lot of man-hours over the past 10 years with very little to show for it. regulators or legislators,” the bank added.
Concerns about liquidity in the Treasury market come as the Federal Reserve begins to retreat as a heavy buyer of fixed income securities. The central bank increases the monthly roll-off of its balance sheet to $95 billion in September. The central bank has approximately $9 trillion in assets on its balance sheet, composed of both US Treasuries and mortgage-backed securities.
And although the Fed has stepped in to buy U.S. Treasuries during times of market stress, it is “a tenuous long-term solution for the central bank to act as the buyer of last resort of the federal debt,” BofA said.
“It is not structurally sound that US public debt becomes increasingly dependent on Fed QE,” BofA said. “It is risky in our view to rely on the Fed alone to solve the problem of liquidity, resilience and the functioning of the Treasury market.”
Instead, BofA thinks a better long-term solution is to create a dealer of last resort that isn’t the Federal Reserve, which is governed by its dual mandate of price stability and low unemployment.
“We believe that such an entity should be formed before a crisis requires it. A broker of last resort could create markets in a wide range of cash securities, futures, swaps, stocks , bonds, currencies, commodities, just like the big international brokers do today,” BofA said, adding that it should be structured as a government-sponsored company.