U.S. Treasurys, frequently cited as the safest asset in town, are increasingly getting caught in a liquidity crunch. The widening gulf between older, so-called “off-the-run” Treasury notes and their “on-the-run” counterparts is a signal that the U.S. bond market is in turmoil.
Under current market dynamics, off-the-run Treasurys should be expected sell at a slight discount to on-the-run bonds. The markets are convinced that borrowing costs (interest rates) are about to move higher this December, which would lift bond yields across the board as the higher rates are factored in. It’s the disproportionate size of the discrepancy that’s freezing up the market.
The discount on older debt relative to newly-issued T-notes hasn’t been this big since the bond crash that hit the U.S. markets in Fall 2013. As a result of this trend, primary dealers (a total of 22 major financial firms) are in most cases retreating from their traditional role as middlemen in the Treasury market. These dealers provide liquidity to the market, but when there is one-way action, their role becomes superfluous.
With a December rate hike imminent, people have been dumping Treasurys. This drives yields higher (and prices lower), making off-the-run bonds less and less attractive.
This wouldn’t be as much of a problem if banks weren’t caught in the process of cutting their balance sheets in order to meet new capital constraints that have been put in place to deter banks from taking excessively risky or overleveraged positions. For this reason, banks aren’t engaging in many repos (repurchase agreements), which typically provide an avenue for certain funds and dealers to turn over their cash into (in the words of the Financial Times) “high quality collateral” such as T-bonds.
With these dislocations in the bond market, it means that it’s more difficult than usual to find consistent buyers for U.S. Treasurys—i.e. liquidity is drying up. Although many portfolios include Treasurys with the intention of holding them until maturity, a liquid bond market is an important way that short-term financing properly flows through the financial system.
It remains to be seen how bond traders and their broader markets will respond when the Fed finally does raise rates. Regardless, it begs the question: How truly safe of an asset are government bonds, even the standard-bearing U.S. Treasurys, if you can’t reliably sell them when you want to (or have to accept a much lower price)? Gold and silver, by contrast, are readily accepted for their full intrinsic valuable wherever you are in the world.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.