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Troubles Percolate in the Plumbing of Wall Street Troubles Percolate in the Plumbing of Wall Street
(about 7 hours later)
Conditions in bond markets had been growing dicier all week, but Wednesday afternoon was a tipping point: Investors across Wall Street reported that Treasury bills and bonds were becoming hard to trade. While most investors have been focused on the rapid decline in the stock market, which had its worst day since the crash of 1987 on Thursday, a different drama is going on behind the scenes on Wall Street — potentially with bigger implications for the economy.
Yields swung wildly. There were few sellers and buyers for older bonds, and a huge gap between what they were asking for and offering. And while it was difficult to point to the root cause of the sudden lack of liquidity — the ability to buy and sell securities at a reasonable value — calls for help were widespread. The swift, global spread of the coronavirus has chipped away at one of the cornerstones of the financial system: the vast market for bonds, where companies and governments go to borrow money to fund operations. Wall Street banks, as well as sophisticated investors such as pension funds and hedge funds, trade these bonds, including the government debt that is considered among the safest assets in the world: United States Treasuries.
“Liquidity conditions in the Treasury market look troublingly poor” and “repo markets are now showing signs of serious strain,” economists at Evercore ISI wrote in a research note. “We think the Fed needs to act now.” But in recent days, as fears of a pandemic have escalated, the market for Treasuries has experienced a liquidity problem — meaning that the buying and selling of this kind of debt at reasonable prices has suddenly gotten a lot tougher. That, in turn, made already nervous investors even more frantic on Thursday, when the S&P 500 index plunged so far and so fast that trading was temporarily halted. Stocks closed down 9.5 percent, the worst performance since Black Monday more than three decades ago.
The central bank did, on Wednesday afternoon, boosting the size of the temporary loans it has been making to eligible banks and adding ones that extend over a longer period of time. Those changes to the repurchase, or repo, operations were an attempt to keep money markets calm, the second time this week officials had ramped up their offerings. The drama in the Treasury market prompted the Federal Reserve Bank of New York to step in on Thursday, saying that it would quickly offer banks $1.5 trillion in funding, via short-term loans, to keep the bond markets functioning smoothly.
But many investors are looking for an even more aggressive response as economic fears stemming from the coronavirus send a jolt through global markets, ending the bull run in stocks, causing companies to tap credit lines and raising widespread concern that the sort of cash crunches that fueled the 2008 financial crisis could again materialize. That decision illustrates just how central the Treasury bonds are to the economy. They form the bedrock of the entire bond market, because interest rates on all types of bonds are set based on Treasury yields. Any signs of distress involving these bonds — a rare occurrence — means bigger problems could be underfoot for the financial system.
“Markets are trading as if the major liquidity providers are simply stepping away from them,” said Guy Lebas, chief fixed income strategist at the investment manager Janney Montgomery Scott.
While a crucial market for short-term loans between banks and other financial institutions remains functional, signs of stress are beginning to materialize. One key gauge of short-term funding strains has been worsening.
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“There are tremors at the moment in funding markets,” said Gennadiy Goldberg, a rates strategist at TD Securities. “There’s not a crisis, but there are tremors and a whole lot of uncertainty.” For instance, it could mean borrowing costs are higher than they should be for local governments trying to raise money, homeowners trying to refinance mortgages and businesses trying to fund their operations.
The disorder in the bond market resulted in the breakdown of key relationships between different kinds of investments that traders and investors rely on in order to hedge the risks of their portfolio. “If you don’t know where the safest asset in the world is, it becomes next to impossible to figure out where everything else is,” said Rick Rieder, chief investment officer of global fixed income at BlackRock.
For instance, when stocks fall sharply, prices of U.S. government bonds — the haven of choice for global investors — should go up, helping to mitigate the losses on stocks. But on Wednesday, that did not happen. As the S&P 500 collapsed, bond prices fell sharply too — pushing yields, which move in the opposite direction, up — and breaking down perhaps the most basic relationship in markets. Even in a crisis, there is a certain logic to how the markets behave. The U.S. government’s guarantee on its bonds makes them the best alternative to holding cash, so investors tend to buy more of these bonds at the first sign of trouble in the stock markets. Higher demand for these bonds makes their prices go up, which pushes down their yields because there’s an inverse relation between bond prices and the return they generate.
“The sun rises in the east,” said Ajay Rajadhyaksha, an analyst with Barclays in New York and a member of the Treasury Borrowing Advisory Committee to the Federal Reserve Bank of New York, a group of top Wall Street executives who advise on conditions in the Treasury market. That was the case last week, when yields fell to record lows as stock prices slid amid worsening news about the coronavirus outbreak.
“You also know when things go bad, Treasuries rally, and if they don’t, that is incredibly problematic.” He added: “That’s when you begin to get concerned about whether markets are breaking down.” But things began changing this week as investors sold Treasuries too, upending the conventional wisdom and causing prices of those bonds to plummet.
The Fed has fixes if the problems persist. It could reinvigorate the crisis-era term auction facility, through which the central bank auctioned 28-day and 84-day loans to some deposit-taking institutions to help ease funding strains. It could make the currency-swap lines it has in place with other global central banks more attractive, ensuring that foreign markets have plenty of dollars flowing through them. “When things go bad, Treasuries rally, and if they don’t, that is incredibly problematic,” said Ajay Rajadhyaksha, an analyst with Barclays in New York and a member of the Treasury Borrowing Advisory Committee to the Federal Reserve Bank of New York, a group of top Wall Street executives who advise on conditions in the Treasury market. He added, “That’s when you begin to get concerned about whether markets are breaking down.”
Or it could even take a page out of its November 2008 playbook and buy assets for purely technical reasons, to make sure that they continue trading smoothly, some economists said. Back then, the Fed jumped into the mortgage-backed security market, providing an escape valve for rapidly building pressure. On Wednesday afternoon, investors across Wall Street reported that Treasury debt, especially certain kinds of older bonds, was becoming hard to trade. Bond yields swung wildly. A huge gap emerged between what buyers of bonds were offering and what sellers were charging.
Already, the Fed is buying $60 billion in Treasury bills each month, so some have speculated that it could simply extend that program, which is slated to run through at least April before tapering off on an as-of-yet undetermined schedule. The mismatch could be temporary. Some big investors, which can hold billions of dollars’ worth of Treasuries, may be selling to avoid further volatility. Some hedge funds that make big bets on typically minuscule movements of Treasury yields have also responded to the enormous swings by dumping their holdings of government debt.
The question is what would be most helpful — and because it is hard to know exactly what is going on, that is a matter up for some debate. But it’s causing a problem for banks, whose trading desks buy and sell these bonds and act as the middlemen of the market. In a highly liquid market, banks are able to match buyers and sellers easily, because there are only very small differences in the prices sellers are offering and buyers are willing to pay. But this week, as the difference in prices — the spread — widened, analysts said banks were left holding large volumes of bonds they couldn’t immediately sell. That dissuaded them from buying more, causing the market to dry up.
Part of the issue with trading Treasuries and other bonds, strategists have speculated, is that traders have been sent home or to backup locations amid coronavirus quarantines. With more physical distance, communication is harder, and it may have lead to technological breakdowns. With few players active, the traders who were buying and selling had an outsize influence on bond prices. Market depth, a crucial measure of Treasury market liquidity, has declined to levels last seen during the 2008 crisis, based on data compiled by JPMorgan Chase.
But something more fundamental could be at play. Companies and financial players alike seem to be increasingly cautious about their future sources of funding. Blackstone Group and Carlyle Group, both private equity giants, told the companies they invest in to draw on their lines of credit in case cash becomes scarce, Bloomberg reported on Wednesday. The situation remained strained on Thursday, although it was somewhat improved from the previous day, said Munier Salem, vice president for fixed income strategy at JPMorgan. “Everyone has pulled back,” said Mr. Salem, who added that he expected things to get better or stabilize. “There’s diminishing capacity for it to get much worse.”
As banks ready themselves to lend out money to their corporate clients — changes that require them to keep more capital in reserve — they might be less willing to lend into financial markets, Mr. Lebas said. The virus, which has forced sports leagues to suspend play and forced legions of employees — including traders — to work from home, poses challenges that stretch beyond the usual stresses at a time of financial uncertainty. Some strategists suggested the physical distance between traders now working remotely or from backup offices had hampered communication and complicated the smooth movement of Treasuries and other bonds.
“If I’m a bank treasurer and I’m seeing this unwind, I’m worried about a run on the banks,” he said. “It’s not the depositors; it’s the creditors.” The Fed’s decision to step in on Thursday was its latest attempt to steady crucial financial machinery. Earlier this week, it sharply increased the size of the temporary loans it makes to eligible banks and extended many of those loans over a longer period of time. Its Thursday escalation should help to meet the short-term cash needs of financial institutions. The Fed, which has been buying $60 billion in assets monthly, is also shifting away from short-term Treasury bills and toward a wider range of Treasury securities, which could help further reduce market pressure.
It’s not clear that lines of credit are the problem, Mr. Goldberg said, in part because it is not yet obvious how widespread the drawdowns have become. Marc Lasry, senior principal of the $10.5 billion investment firm Avenue Capital, said that while he believed the economic slowdown would be relatively short-lived, the anxiety of market participants was understandable.
But both Mr. Lebas and Mr. Goldberg pointed to regulation as a key driver of the lost liquidity. When primary dealers — banks that are key market makers — snap up too many assets, it throws their regulatory ratios out of whack. Amid market gyrations, they may have simply filled up their balance sheets, making them more reluctant to buy securities such as older Treasuries. “When everybody wants to be in cash, as opposed to financial instruments, that’s when you start having issues, and that’s what’s happening now,” Mr. Lasry said.
“It’s crunchtime, and the balance sheet just isn’t there,” Mr. Goldberg said. Kate Kelly contributed reporting.
The Fed’s repurchase operations can allow dealers to fund their large holdings of Treasuries and agency securities, but are a limited fix, because they do not change the regulations that effectively limit balance sheet size.
But for now, the short-term cash injections are helping to keep funding markets functioning. The Fed’s longer-term repo offerings on Thursday morning were both oversubscribed, meaning eligible banks asked for more of the 14- and 25-day loans than the Fed was offering, as unsettled markets continue to drive demand for stable dollar funding. But the Fed’s overnight offering was underbid, suggesting that there is no current shortfall.
The key question now is whether trading trouble will prove short-lived as banks reorient to life under quarantine and whether funding pressures become more disruptive.
“Significant damage has been done in the last few days, and casualties may well surface in the days ahead,” Krishna Guha and Ernie Tedeschi at Evercore ISI wrote in a research note Wednesday. “If the Treasury market remains dysfunctional the Fed will have to ramp up repo in the coming days at greater term.”