Potential Solutions Lie in Fed Policy, Market Recovery
Fortunately, there are potential solutions to the Treasury liquidity issue.
One is for federal regulators to repeat what they did in March 2020—namely, relieve market makers of SLR requirements that include US Treasuries. This move improved market liquidity considerably, as the Fed itself acknowledged. There’s reason to believe the Fed would go this route again, after new vice chair for supervision Michael Barr suggested to lawmakers that he’d consider changes to SLR requirements.
Liquidity bottlenecks may also be resolved without central-bank or regulatory intervention through better market conditions.
While inflation remains elevated in stickier categories, Fed policy may be having an impact. Lower inflation and less economic uncertainty could reduce volatility in the bond market and increase market depth—improving liquidity in the process. As the Fed and other large, developed-market central banks approach peak forecasted interest rates, it’s not unreasonable to believe that bond-market conditions could improve.
In the meantime, if the US economy falls into a mild recession over the next 12–18 months, we expect increased demand for Treasury securities, as risk assets come under pressure and expectations for interest rates shift to a lower-growth, disinflationary environment.
Another welcome outcome would involve a decline in the US dollar and subsequently lower hedging costs. We expect this would re-engage some foreign investors who have withdrawn from US Treasuries to stabilize domestic currency valuations and deploy assets for local financing needs. In turn, this increased foreign investment could fill another void in end-user demand.
Additionally, a proposed Treasury swap program that would replace off-the-run bonds with on-the-run issues could provide a reprieve by moving a percentage of bondholders to the most liquid issues.
Ultimately, the solution could involve one or more of these scenarios, as friction in the US Treasury market stems from restrictive monetary policy, limited dealer balance sheets and evaporating excess demand from traditional buyers of Treasury securities. In our view, a reversal in any of these factors, should improve market liquidity—particularly if the Fed engineers a soft-landing scenario, avoiding any further volatility and market dislocations that would come from a deep recession.
For investors, liquidity is a risk factor, much like interest-rate risk and credit risk. Shifts in market dynamics can create investment opportunities in less-trafficked parts of the Treasury yield curve, or in related markets and financial instruments. Given the proper framework for managing risk, market dislocations can result in compelling investment opportunities.