This month, a mystery of the “thriller” – or “what did he do” – looms over the markets. No, this is not about price fluctuations of bitcoin or GameStop stocks.
Instead, the problem is the $ 21 billion US Treasury bill sector. In March 2020, as Covid-19 hit the west, Treasury prices went haywire as market liquidity plummeted. This was shocking in a sector that is normally “the largest and most liquid government securities market in the world,” according to the Federal Reserve.
Fed officials finally unblocked the market with unprecedented interventions, engulfing Treasuries itself. After peace returned, some investors – and politicians – seemed willing to sweep this horror under the rug. But, a year later, we have to solve the mystery of what happened for three reasons. First, the system is on the brink of disaster. Or, as Randal Quarles, a Fed governor, observed: “For a while in the spring [of 2020] the result has been – as the Duke of Wellington said of Waterloo – “one hell of a thing up close”.
Second, the bond market will face further stress if (or when) US monetary policy tightens. Last week, markets started to turn alarmingly again as inflation fears surfaced.
Third, the source of the March unrest is not widely understood. This is confusing if you want to design a policy to avoid duplication. Initially, the Fed’s research suggested that hedge funds were responsible. Shortly after the event, Fed officials reported that “leveraged investors who bought treasury bills in the spot market and hedged interest rate risk with futures contracts began. to unwind these positions as the prices of the futures contracts increased, causing a feedback loop ”.
This brought back memories of the 1998 debacle around the long-term capital management fund and prompted the Financial Stability Board to call for action to “address the vulnerabilities of non-bank financial intermediation”. that is, more supervision and control. This call makes sense in general. The NBFI sector has exploded since 2008 and remains alarmingly opaque. Few observers even knew that hedge funds were also exposed to Treasuries before March 2020.
But a subsequent Fed investigation also suggests it’s a mistake to blame only the hedges. One of the reasons is that foreign institutions have also dumped treasury bills in a destabilizing way. Second, the behavior of some of the big Wall Street banks was strange. Over the past few years, they have acted happily as market makers in the treasury bill industry as they hold large amounts of such bonds. Specifically, brokers play a crucial role in repo markets where investors raise funds by swapping bonds for cash, thus lubricating the cogs of finance.
But late last year, a New York Fed report noted that during the turmoil of March 2020 “compared to normal times, brokers did not make their securities available to other market participants.” , even though their stocks of treasury bills had jumped. Clearly, this means that the brokers went on strike in secret. The crisis was not just a problem of demand – no one would buy Treasuries – but a problem of supply, as brokers had stopped trading, even for pensions.
This is alarming, because it highlights more important structural problems. Quarles believes the March debacle shows that the $ 21 billion treasury bill market “may have exceeded the capacity of private market infrastructure to withstand stress of any kind.” Part of the reason is that the US debt keeps growing. But it is also because the post-2008 reforms increased the capital buffers banks need to engage in market-making activity, which made them hesitate. Either way, the situation is like an always inflated elephant balancing on a shrinking ball: if the ground is still, the situation may seem stable; but, if not, it is easy to tumble.
Can this be fixed? Not easily. The Biden administration is unlikely to implement a rollback of the post-2008 reforms. It is even more unlikely to reduce debt. But a recent article from the Brookings Institution describes some policy options, such as better tracking of NBFIs and regulatory adjustments that make it easier for brokers to be market makers.
More controversial, the document also calls for “a serious consideration of a mandate for a broader use of central clearing for Treasury securities” and “a new permanent pension facility from the Federal Reserve that would serve as support for the financial system. US by providing funding to regulated brokers. based on guarantees from the US Treasury and agencies ”.
Could it fly? The latest idea is already being implemented on a supposedly temporary basis, as the Fed only curbed the tragedies of March 2020 by introducing “emergency” measures to support the repo markets. This is a striking extension of the central bank’s role, but it has attracted little protest, probably because few foreigners understand the repo.
But relying on ad hoc emergency measures is not a good way to formulate policies, not least because it creates moral hazard. So, as the March anniversary approaches, the Fed should explain to the public in easy-to-understand language what created the problem and how to avoid a repeat.
In this regard, it would make sense to create a permanent pension facility. There are big drawbacks to extending the Fed’s tenure (again): no one wants the system to become even more dependent on central banks. But we cannot afford to have the Treasury bill market overwhelmed again, especially as inflation fears intensify.
