The U.S. Treasury market has never been larger or – in some segments – as active. So what are the challenges and the possible warning signs that investors should be heeding?
1. Ballooning supply. The size of the Treasury market is increasing monthly, with continued net new issuance, despite QE. The prospect of even more issuance to fund larger budget deficits is a real possibility as is the reduction of Treasury holdings in the Fed’s SOMA portfolio. Orderly funding at relatively low rates cannot be taken for granted as the dealer community comes under pressure to move debt in a rising rate environment.
2. Demand outstripping supply. Even with the growth in outstanding Treasuries, demand from genuine buy and hold end-user investors is rising at a time when the pool of highly rated sovereign assets has shrunk following the financial crisis. Demand from bank treasury departments and clearing houses as well as money flowing out of traditional money market funds into Treasury Prime funds is adding to the pressure. The majority of this demand is concentrated in the short-end of the yield-curve.
3. Regulatory overload. The Dodd-Frank Act and Basle III are weighing down banks and increasing the cost of their front-line businesses. However, uncertainty is growing given potential regulatory changes that may be coming from the new Administration and Congress.
4. Cost of capital. It’s expensive to fund businesses, none more so than in capital-intensive rates businesses, such as U.S. Treasuries. Rising costs of capital and regulation puts a premium on balance sheet allocation to more profitable businesses.
5. Increased transparency. Electronic trading has increased price visibility, primarily for on-the-run Treasurys, leading to ongoing pressure on bid/offer spreads. However, increased transparency has led to a bifurcated market where price visibility has actually reduced the liquidity for off-the-runs and TIPS.
6. Reduced ROE. Return on Assets (ROA) has always been a challenge for Treasury trading desks but, in general, ROEs have been acceptable. We are now seeing a convergence of the two as ROAs rise as ROEs decline. The result is banks are making less money and that means less capital available to support trading operations.
7. Episodes of extreme volatility. While price movement is good for traders, that’s only the case within certain boundaries. If market volatility becomes sufficiently extreme it could create economic uncertainty, which could hurt growth, reduce tax receipts, and undermine the orderly conduct of monetary policy.
8. Fed under fire. Questions exist about the ability of the Fed to successfully manage a tightening of monetary policy and its ability to unwind the SOMA portfolio.
9. “Heads in the sand”. Regulators are reluctant to acknowledge the ‘inconvenient truth’ that there are major liquidity issues for off-the-run securities and TIPS, particularly for trades larger than $100 million.
10. Trade reporting. There is a danger that public dissemination of trade reporting risks undermining confidentiality and liquidity at a time when regulators need market transactions go be more fluid and optimal.
It’s a lot to worry about. The good news is that the problems are mainly concentrated in two areas of the Treasury market – off-the-runs and TIPS. On-the-run Treasuries are very actively traded, including by fast money accounts, although that may be scant comfort for asset managers and other buy-and-hold institutional investors.
Michael Paulus has over 30 years of financial markets experience in both the public and private sectors, including senior positions at both the Federal Reserve Bank of New York and the U.S. Treasury Department.