A lot is going to change in the next few years for the US Treasury market. Not all of this will be good for the stability and health of the primary funding source for the U.S. government. But the evolving role of primary dealers means that, for many, acting as riskless principals could allow them to increase profitability, while deploying less capital at the same time.
The volatility that the bond markets experienced on October 14, 2014 was unlike any other, not due to the extent of the price swings but because of the impact on the market. After all, as a reader pointed out in response to my previous share, the volatility and price moves in the 1970’s and early 1980’s were likely larger and more frequent. But as the American psychologist, Noam Shpancer said, “context determines the meaning of things.”
The idea of a U.S. Treasury buyback program has major drawbacks for the U.S. Treasury, end-investors, and even the Federal Reserve. Indeed, buying back off-the-run Treasuries (OFTRs) to create jumbo on-the-run (OTR) benchmarks will inadvertently lead to further deterioration in the OFTRs, the sector of the market that accounts for 98% of all Treasury issuance.
The root of the issue with Treasury buybacks lies in the bifurcation of the market, with trading of OTRs dominated by principal trading firms (PTFs). Helping this constituency by bolstering the size of benchmark issues does not add to the stability of the overall market. In contrast, genuine long-term holders of the government’s debt are concentrated in the OFTRs. While these real money investors may use OTRs to adjust duration (or when they need immediate access to liquidity), portfolio re-balancing is often done in cheaper OFTRs.
The Fed and the Treasury describe the U.S. Treasury market as, “the deepest and most liquid government securities market in the world.” While arguably true for the six on-the-run (OTR) benchmark securities, those six securities make up less than 2% of the total $13.4 trillion of total outstanding supply. It is the other 98%, known as off-the-runs (OFTRs) that should be of greater concern to market participants and policy-makers alike.
Lack of liquidity in a key sector of the government bond market is now costing institutional investors billions of dollars annually in sharply widening bid/offer spreads. This post-financial crisis inefficiency is straining market structure to the point that the traditional principal-based dealer model is not working for either the dealers or the buy-side community. It’s time for a new way of doing business.
The principal area of concern is the off-the-run sector of the U.S. Treasury market, which accounts for more than 35% of all trading activity, according to the Federal Reserve Bank of New York. This sector includes all but a half-dozen of the approximately 296 total outstanding U.S. Treasury issues. The six securities are the most recently issued, or “on-the-run” securities, and are almost 100% traded electronically in a highly transparent market. But off-the-run securities are still largely traded by phone, and that’s where the trouble lurks.
While there is broad agreement about the liquidity challenges of the US Treasury market, there is still much debate on how best to address them.
I had the opportunity to participate in the lead panel discussion at the TabbForum Fixed Income Conference: Panel Discussion Video . I spent a reasonable amount of time addressing the multiple layers of bifurcation in the Treasury market, and why it was necessary to include the entire curve (and not just the six most recently auctioned securities) in any discussion about the changing market structure.