(Update: a couple of hours after I posted this, the NY Fed announced $1.5trn increased repo operations and $60bn of monthly purchases. This should help, but I think the Fed should still consider temporarily suspending bank capital and liquidity requirements as described below, then call the big banks and strongly encourage them to make two-way prices.)
A lot of people are wondering what happened to market liquidity in US Treasuries? The liquidity regime implemented after the 2008 global financial crisis places a large emphasis on banks holding HQLA. The L in HQLA stands for Liquid — High Quality Liquid Assets. So, are Treasuries still liquid? Are there still enough buyers and sellers in what many people consider the world’s safest asset class? The coming days and weeks will be important for bank liquidity managers around the world. I believe it is time for the Fed to take more dramatic action to prevent a greater market shock.
US Policy Response So Far
The Fed has attempted to calm markets in the last few sessions, as global markets reacted to Covid-19. Firstly, the Fed cut rates by 50bps in an unscheduled move on 3 March — this was a very dramatic move from the Fed, because they had not cut rates by 50bps since the crisis, and not in an unscheduled move. In fact, from the Fed’s perspective, this was probably so dramatic that they expected markets would calm down afterward.
But markets did not calm down.
On 5 March, banks’ demand for cash in the Fed repo operations was above expectations. This was an early sign of trouble. On 9 March the New York Fed announced they were increasing the scale of the repo open market operations by increasing them from $100bn to $150bn for overnight repo and from $20bn to $45bn in 2-weeks, in response to the increased demand for cash from banks. 9 March also happened to be the worst day for stock markets since 2008.
Yesterday there was no liquidity in US Treasuries for market participants that wanted to buy and sell them (more on this below).
Last night, 11 March, the NY Fed announced another increase from $150bn to $175bn in overnight repo operations. The $45bn 2-week operation was extended to Friday and three $50bn 1-month operations were added. The 2-week and 1-month operations executed this morning were oversubscribed — banks wanted more cash, even after the Fed increased the amount of lending last night.
Why Such Panic?
Looking at the latest data that is publicly available about holdings of Treasuries and the related market rates, there is no sign that US Treasuries market should be so dislocated. Admittedly, the public data is not quite up to date, which might be the issue. The most recent data from the Fed for the Secured Overnight Financing Rate (SOFR) on 11 March covering repo transactions in US Treasuries shows that the rates are normal — no panic there. The data for 10 March for Effective Fed Funds show that the unsecured rates are in line with the Fed rate cut — no panic there either. According to the NY Fed data, US primary dealers’ holdings of US Treasuries rose in the week ended 26 Feb, but only to levels seen earlier this year — no major sign of stress. In the same data set from NY Fed, primary dealers’ Treasury repo positions on 26 Feb were not dramatically different.
So, is the dislocation now comparable to the dislocation we saw in US repo markets on 17 September that drove US Treasury overnight repo rates from 2% to 10%? In short, I think the answer is no. Logically, markets should not have the same liquidity problem now as seen in September. The analysis since September concluded that the Fed was reducing its balance sheet, which drove down excess reserves in US banks, causing a cash squeeze when excess reserves reached about $1.2trn, which in turn caused repo rates to spike. Since then, the Fed has started repo operations, repo rates normalised, and excess reserves rose to about $1.5trn as of 26 Feb. So, there shouldn’t be the same squeeze as we saw in September, especially because we haven’t seen a build-up of Treasuries in primary dealers recently. Also, in September, part of the problem was that corporate tax day and US Treasury issuance drained reserves from the system, which is not the case now. But the increase in demand for the Fed repo operations tells a worrying story.
US Treasuries Move
The US Treasuries yield curve has been volatile in the last few sessions. Firstly, investors bought Treasuries in a risk-off move, causing 10-year yields to fall from 1.6% mid-February to below 0.4%. Some commentators suggested buyside firms were buying Treasuries to lock in yield in case the yields fell even further. In recent days 10-yr yields moved back up to 0.8% before falling again to 0.66% today. On Wednesday, yields rose when the stock market fell, which normally doesn’t happen. It is difficult to judge whether Treasuries were over-bought in recent days and now yields are normalising, or whether something else is going on.
What is clear is that there is a problem with market liquidity — there are much fewer buyers and sellers. The proprietary trading firms like Citadel that were making markets and providing market liquidity in US Treasuries in recent years have widened bid-ask spreads and reduced trading volumes. Yesterday, JP Morgan analysts highlighted that the market liquidity in 30-year US Treasuries is at its lowest level since 2008. Bank of America also sent a note to clients explaining that it was a difficult day for market liquidity and calling for a rapid and large response from policymakers.
Today is another terrible day for the stock markets, with stock markets down 5% or more. It will be an interesting day for US Treasuries.
International Policy Response
Yesterday in the UK, the BoE and the Exchequer admirably announced coordinated monetary and fiscal action by cutting rates by 50bps and announcing stimulus measures. Importantly, the BoE also announced a measure to encourage bank lending — they removed the countercyclical capital buffer.
Today, the ECB did not deliver the rate cut that the market expected, but they announced EUR120bn in additional quantitative easing and changes to their Long-Term Repo Operations. Yields on Italian bonds jumped from 1.25% to 1.5% after the news, suggesting that markets expected more action. The FTSE was muted yesterday in spite of the BoE and Exchequer measures, until Trump’s travel ban caused a 5% fall this morning, alongside large falls in other European equity markets. Markets have not recovered following the ECB announcement.
Very importantly, the ECB went a step further than the BoE in encouraging bank lending — they changed both the capital and the liquidity requirements. The ECB temporarily removed the minimum Liquidity Coverage Ratio (LCR) requirement, they removed pillar 2 capital requirements and allowed for capital that is not considered Core Equity Tier 1 to be included in bank capital measures. It will be interesting to see how quickly European banks will react to this by buying stocks and non-HQLA bonds, and increasing their lending.
Recommendation for US Authorities
Now, I believe it is time for the Fed and the US Treasury department to take measures a step further than the ECB, especially in light of the dislocation in US Treasuries, but also in light of the fact that many US states have only begun testing for Covid-19. The situation in the US is likely to get worse from here.
I would recommend to the Fed to temporarily suspend the bank leverage ratio and the Fed should strongly encourage banks to make two-way prices in bond and repo markets. This will mean that if there is a credit repricing over the coming months, as expected , it will be more orderly. A disorderly credit repricing will be very bad for the US economy.
I believe the Fed should also follow the ECB by temporarily removing the LCR minimum requirement. They should temporarily allow for breaches in capital ratios, and also temporarily allow for breaches in internal liquidity stress tests. I believe that is the scale of the measures required to avoid market disorder and restore market liquidity in US Treasuries in the medium term, in addition to the US Treasury buyback of $50–100bn that JP Morgan proposed to calm the US Treasuries market in the short term. Restoring calm in markets should not be solely the responsibility of policymakers. The combined balance sheets of the US banking system will bring far more firepower to the US economy than a policy response can on its own.
These proposed measures may seem dramatic, but they are temporary measures and can be unwound, whereas the risks building up in US Treasuries and other markets could create market moves that will be far more dramatic.