Treasury Market on the Brink: A Liquidity Crisis Looms

Liquidity Deterioration in the Treasury Market

The Treasury market is teetering on the edge as liquidity continues to evaporate, posing significant risks for bond investors. The Treasury Liquidity Index has surged to its highest level since the Global Financial Crisis (GFC), indicating worsening conditions. This index, which compares yields to a fitted curve, suggests that the further yields deviate from this curve, the poorer the liquidity.

• Treasury Liquidity Index: Recently hit its highest level since the GFC, signaling deteriorating liquidity conditions.
• Market Depth: According to a New York Fed article, market depth has been severely challenged by the pandemic, bank failures, and interest-rate uncertainty. Depth plummeted in March 2020 and again after the SVB collapse in March 2023, remaining significantly lower than pre-pandemic levels.
• Liquidity Risks: The DKW model shows that liquidity risks have been the single biggest driver of higher yields this year.

The upcoming CPI update and Federal Reserve meeting will test the stability of the Treasury market. Market participants are expecting CPI to show that the recent rise in inflation was a temporary blip, but underlying risks suggest this may be overly optimistic.

Inflation Complacency and Rising Supply

Complacency about inflation and an overly negative growth outlook are contributing to the precarious state of the Treasury market. Despite inflation remaining stickier than expected, market expectations are diverging from consumer expectations, leading to a mispricing of inflation risks.

• Inflation Expectations: Market's inflation expectations are increasingly diverging from those of consumers. CPI fixing swaps expect price growth to return to under 2.5% within a year, despite inflation remaining well above target.
• Consumer Expectations: Near-term consumer inflation expectations have been rising, leading to markedly different inflation curves. The consumer expectations curve is fully inverted, while the inflation-swap curve is positively sloping.
• Breakevens: 10-year breakevens remain subdued at around 2.3%, indicating that yields are not priced for inflation risks.

At the same time, the Treasury is increasing the supply of longer-term bonds, further straining the market. While bill issuance remains high in notional terms, the duration-adjusted issuance of bonds has started to rise markedly.

• Bond Issuance: The Treasury is pulling back from selling bills and issuing more longer-term bonds. Duration-adjusted bond issuance has increased significantly.
• Fed's Role: The Fed will taper QE this month but will not be a buyer of bonds, meaning the market must absorb this extra duration.

A Thought

The Treasury market is facing a perfect storm of deteriorating liquidity, inflation complacency, and rising supply. While the Fed's tapering of QE may offer some relief, the underlying risks suggest that bond investors should brace for more volatility. The market's current optimism may be misplaced, and a more cautious approach is warranted as we navigate these turbulent waters.