The US Treasury bond market, worth around $24 trillion, is considered the largest in the world. Its smooth operation has a direct impact on both America’s ability to run its government and the health of the wider financial system, which depends on traders’ view that US debt is a safe bet.
So what would happen if the Treasury market were to experience a sudden breakdown?
It’s a question that US officials and Wall Street banks are present more often since the UK experienced a collapse in its own government bond market. The Bank of England was forced to organize an emergency intervention.
Fears smolder that a showdown between Republicans and President Joe Biden over the debt ceiling in 2023 could present a similar moment of judgment.
“America should not be held hostage by members of Congress who think it is okay to jeopardize America’s credit rating and threaten to default on U.S. Treasury bonds, which are the foundation of global financial markets,” Treasury Secretary Janet Yellen told CNN on Thursday. .
US debt trading has been tighter than usual as uncertainty keeps investors on the sidelines and central banks and foreign governments look for ways to prop up their struggling currencies.
This stokes fears that a sudden shock, if it were to occur, could be particularly shocking.
“Most recognize that there is underlying fragility in the market today,” said Mark Cabana, head of US rates strategy at Bank of America. “Fragile things can break easily.”
Yields on benchmark 10-year Treasuries, which move opposite to prices, have risen sharply, topping 4.2% this month, from just 2.6% in early August and 1.5% in early August. of the year.
These large moves in the typically incremental world of government bond trading reflect a drop in demand.
While Treasuries generally serve as a safe haven in times of uncertainty, the lack of clarity over how long the Federal Reserve will continue to raise interest rates – and how long high inflation will persist – makes more hesitant traditional buyers.
Yellen said his agency was monitoring the situation closely, acknowledging that the deals “reflected greater uncertainty about the economic outlook,” although “volumes are robust and investors are able to execute trades.”
“Treasury is working with financial regulators to advance reforms that improve the ability of the Treasury market to absorb shocks and disruptions, rather than amplify them,” she said in a speech this week.
Treasuries aren’t immune to turbulence when markets start to go haywire, if recent history is any guide. In March 2020, for example, fear of the coronavirus pandemic caused rare disruptions. The Federal Reserve was able to restore confidence, but only after announcing that it would buy government bonds massively.
For now, the market appears tense but under control. But Brad Setser, a senior fellow at the Council on Foreign Relations who studies financial vulnerabilities, pays attention to the extent to which central banks or governments in countries like Japan offload Treasuries.
As the US dollar embarked on a dizzying rally, sending other currencies plummeting, authorities stepped in to try to limit the damage. Japan, for example, tried to support the sinking yen, which recently fell to its weakest level against the US dollar since 1990.
While official data often lags, Setser, a former adviser to the Biden administration, said there’s “growing evidence that some central banks are starting to become modest sellers of Treasuries.” .
The Federal Reserve also began to reduce its holdings around the time of the pandemic, a process known as quantitative tightening. An increase in the supply of bonds could push yields even higher if demand remains subdued.
“The amount of Treasuries the market has to absorb is obviously going to increase with the Fed’s quantitative tightening, and uncertainty about the path of interest rates creates more intrinsic volatility in the market,” Setser said.
Signs that the Treasury market is trickier than usual are putting investors and regulators on alert, especially after what happened recently in the UK.
An investor revolt against plans unveiled by former Prime Minister Liz Truss in September to cut taxes while increasing borrowing has sparked chaos in the government debt market. The Bank of England had to announce three separate interventions to restore calm as pension funds that relied on derivatives came under pressure.
“What worries people is what happened in the UK,” said Joseph Gagnon, a former Fed official and senior fellow at the Peterson Institute for International Economics.
The US pensions industry is structured differently than the UK, and many of the factors that triggered the fallout were specific to Britain.
Investor confidence in the UK has declined since it voted for Brexit in 2016, noted Kathleen Day, a senior lecturer at Johns Hopkins University who has studied the history of financial crises.
Still, the episode caught the attention of US government debt traders and policymakers. One concern is that if Republicans gain control of one or both houses of Congress after the midterm elections this fall, they will take advantage of the debt ceiling – which will likely have to be raised in 2023 – as a negotiating tactic with Biden.
“The debt ceiling is probably the biggest institutional oddity in the United States that carries global risk and Treasury market risk,” Setser said.
While tightrope politics over the debt ceiling has become commonplace, the stakes could be higher now that financial markets are on edge.
“If the United States doesn’t raise its debt ceiling and defaults on its debt, that’s an Armageddon moment,” Day said.
Yellen told CNN it was “absolutely essential” that the debt ceiling be raised if necessary.