Trading in the world’s biggest government bond market
has become increasingly challenging as the large banks that support
transactions focus on slimming down their balance sheets. As dealers step back
from facilitating the buying and selling of US Treasury debt, a key measure of
market liquidity has deteriorated sharply and plumbed a level not seen since
the bond rout of 2013, when investors anticipated that the Federal Reserve would
start tapering its quantitative easing policy.
Ahead of an expected shift higher in official borrowing
costs next month by the central bank, investors have been selling
Treasuries, with the rise in yields and decline in prices being compounded by a
tougher operating environment for dealers.
Faced with capital constraints, primary dealers, who are
responsible for underwriting the US government’s debt, have struggled in their
traditional role of being middlemen for investors. That has resulted in the
price of older or “off-the-run” Treasury debt issues cheapening beyond their
usual discount compared with current or “on-the-run” bond benchmarks. Such a
breakdown between older and new Treasury securities typically signifies market
tension and comes when derivatives trading is also being adversely
affected by shrinking dealer support, the prospect of a Fed rate rise and
looming end of the financial year.
Isaac Chang, global head of fixed income at KCG, an
electronic market maker, said the current Treasury market dislocation highlights
the strains on banks’ balance sheets due to increased capital requirements. That
relationship has been exacerbated by foreign central banks selling their
holdings of older Treasuries as they support their currencies against the
dollar. Highlighting the inability of banks to digest large supply and demand
imbalances, their holdings of Treasuries have increased from around $20bn in
July to $60bn.
Money market funds that exchange cash with banks in return
for high quality collateral such as Treasuries via a repurchase, or “repo”,
agreement are bracing for poorer market liquidity in the coming weeks. Banks
say balance sheet pressures have forced them to pull back from the repo
business.
Debbie Cunningham, senior portfolio manager at Federated
Investors said some banks have retreated from repo transactions with money
market funds. The Federal Reserve Bank of New York runs its own repo programme,
allowing investors to trade with it either overnight or for a longer period,
called “term repo”. At the end of the third quarter the Fed expanded its
programme to $450bn. Last week it announced a term repo programme of $300bn
beginning on December 18, soon after the central bank’s meeting.
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