Sep 28, 2022 - Economy

People are worried about bond market liquidity

Illustration of pipes shaped like a dollar sign.

Illustration: Maura Losch/Axios

The market for government debt of big, rich countries like the United States and United Kingdom is, famously, supposed to be the deepest and most liquid on earth. They are the bedrock of the world financial system; bond prices aren't supposed to bounce around like a penny stock.

  • That hasn't really applied in recent days, particularly in Britain. Bond prices are careening around wildly, in ways that indicate serious strains in the global financial system.

Why it matters: Government debt markets are showing signs of the kinds of turbulence and lack of liquidity that, should it persist, will make all financial assets more volatile and make a looming economic downturn worse.

  • It's painful enough when interest rates rise because the Federal Reserve or Bank of England hikes them to fight inflation.
  • It's all the worse if they rise beyond the point justified by those fundamentals. The sense of panic in the market and a lack of liquidity have undermined the desire or ability to buy bonds recently, even at attractive prices.

Driving the news: The BoE announced Wednesday morning it will buy long-term government debt on whatever scale necessary to "restore orderly market functioning." It also delayed the start of its quantitative tightening program meant to unwind securities acquired in its pandemic stimulus.

  • This is an unusual situation, and comes after some of the biggest single-day swings in U.K. interest rates ever recorded. There were reports from the British press that the bank was trying to prevent runs on some pension funds.
  • Britain's central bank is simultaneously tightening policy (by raising interest rates to try to bring down inflation) and, de facto, loosening policy (by buying bonds to try to restore functioning to the bond market).
  • It is a highly uncomfortable balancing act, especially at a time the value of the pound is plunging and the credibility — and competence — of British policymakers is in question.

Meanwhile, things aren't nearly as worrying stateside as they are in Britain. But there are some signs that the market for U.S. Treasuries, a bigger and more globally important market than that for U.K. gilts, is seeing strains.

  • A Bloomberg index that captures illiquidity in the bond market has soared in recent days, to levels only just shy of those reached during the worst of the pandemic in March 2020, Jim Bianco of Bianco Research notes.
  • Probably not coincidentally: This month, the Fed's quantitative tightening has gone into full effect. By design, the Fed right now is seeking to remove liquidity from the market.
  • For that reason, there would probably be a high bar for the Fed to follow the BoE's lead.

What they're saying: "There is no doubt that the Treasury market is illiquid these days, but it is not dysfunctional," said Roberto Perli and Benson Durham of Piper Sandler, in a research note. "Markets can function even with poor liquidity; it is a sharp and fast reduction in liquidity that makes them dysfunctional."

  • "The Treasury market simply is not there, and the Fed won't do anything different unless the situation changes," they write.

The bottom line: These turbulent times in markets could make the economic pain ahead worse. But don't count on the Fed to come to the rescue, given its resolution to bring down inflation.


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