Secretary Yellen Worried About Liquidity in the Treasury Market

Treasury Secretary Janet Yellen participates in a discussion at the annual Freedman's Bank Forum at the Treasury Department in Washington, on Oct. 4, 2022. Michael A. McCoy/Reuters

U.S. Secretary of the Treasury Janet Yellen admitted to being concerned about liquidity in the Treasury debt market during an event in Washington on Oct. 12.

The potential loss of liquidity is a worrying situation, Yellen said in a question-and-answer session following a speech at the event, according to Bloomberg. She pointed out that even though the overall supply of Treasurys has risen, the balance-sheet capacity of broker-dealers to engage in market-making has not increased much. The Federal Reserve’s standing repurchase facility “can be helpful” in providing the market with liquidity, she added.

A key reason why big financial institutions are thought to be reluctant to act as market makers in the Treasury market is the supplementary leverage ratio, which requires capital to be put against such activity. Since the end of 2019, outstanding Treasury debt has increased by roughly $7 trillion.

When the COVID-19 pandemic hit, the Fed began purchasing $80 billion worth of Treasurys every month to keep the economy stable. Now, the central bank is doing the reverse—offloading up to $60 billion worth of Treasurys per month.

In a recent note to clients, strategists at Goldman Sachs warned that any volatility shock in the Treasury market can trigger further deterioration in market liquidity. In recent times, trading in U.S. Treasurys has seen some of its largest swings since the beginning of the pandemic.

“While we don’t anticipate any issues with the Fed’s current QT [quantitative tightening] plan in the near term, the odds of an accident will likely rise as we go deeper into the QT process,” the note said, according to Bloomberg.

Greg Recine, vice president of MSCI Research, believes liquidity in the Treasury market might become worse in the future as the Fed “aggressively reduces” the size of its balance sheet.

“Investors in U.S. Treasurys may face higher transaction costs, and institutions hedging with U.S. Treasurys may incur greater trading losses resulting from hedge slippage,” Recine said, according to ETF Stream.

Shrinking Portfolios, SEC Reforms

With the Fed focusing on QT, the central bank is no longer the biggest buyer of Treasurys, raising the question of what will plug this gap. America’s large commercial banks are reportedly shrinking their securities portfolio when compared to 2021.

As of Oct. 5, the Fed had purged $81 billion from its holdings. This is the most extreme outflow in Fed holdings since March 2020.

Meanwhile, the U.S. Securities and Exchange Commission (SEC) has proposed a measure to boost the use of central clearing in the Treasury market. The move is said to be aimed at improving the resilience of the $24 trillion market.

The Depository Trust and Clearing Corporation (DTCC) raised concerns about the proposal, according to Reuters. At present, DTCC’s subsidiary Fixed Income Clearing Corp. is the chief clearer of Treasurys.

“While the risk mitigation and transparency benefits of central clearing are well documented, we recognize the impact the proposal will have on a market structure where bilateral activity has been the ongoing practice for various market participants,” the DTCC said.