US Treasuries volatility is rising amid deteriorating liquidity

As we await tangible signs that the end of Fed rate hikes is near, we remain neutral on US Treasuries.

Rising volatility in the US Treasury market has been linked to uncertainties surrounding the US Federal Reserve’s (Fed) hiking cycle. At the same time, the Fed’s shift from quantitative easing (QE) to quantitative tightening (QT) has contributed to a deterioration in US Treasury market liquidity throughout the year. This new environment has led to a rebuilding of risk premiums on US Treasuries, but we expect the Fed to maintain large bond holdings, meaning that risk premiums could remain well below the pre-QE averages. 

Along with QT, the rising capital constraints on US banks have probably worsened market liquidity. These constraints, mostly regulatory, will take time to change, meaning that it is more likely we see the US Treasury Department buy back off-the-run US Treasuries as a near-term remedy. 

As the rout in UK government bonds in recent weeks shows, a well-functioning repo market is the lifeblood of financial markets, as it provides liquidity and limits the impact of panic selling. Knowing this, the Fed instituted a standing repo facility (SRF) in July 2021 for the Treasury market. However, it remains to be seen whether it will be sufficient to forestall a panic selling. 

The end of QE and US banks’ balance sheet constraints justifies part of the increase in both US Treasuries’ term and liquidity premia, but we suspect that a market that functions better coupled with a more predictable policy rate path could well reduce both risk premia and lead to lower long-term yields. 

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