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By Mike Dolan
(Reuters) – The Iran oil shock has upended rate forecasts and roiled U.S. Treasury markets – driving volatility to its highest in nearly a year and forcing selling that is taking a serious toll on liquidity. The risk is that the tremors spread further.
One of the key attractions of the U.S. Treasury debt market is its sheer scale. At $30 trillion, it is deep enough for the world’s biggest buyers and sellers to move in and out without shifting the price – a rare quality in any asset market.
That matters enormously to foreign reserve managers and sovereign wealth funds seeking a relatively safe, non-domestic global asset to bank their country’s savings – one which they can quickly and easily cash up in national emergencies.
For many, liquidity, market size and round-the-clock trading are as valuable as the return itself. That price-insensitive demand, underpinned by the dollar’s reserve currency status, has long given Washington room to expand its debt pile with little or no market disturbance. But size and liquidity also attract other participants – notably hedge fundsthat profit from highly leveraged positions, arbitraging small pricing anomalies between cash and futures markets. In doing so, they enhance market liquidity.
Estimated growth of that so-called basis trade to over a trillion dollars has made many financial watchdogs anxious – largely because the activity relies on smooth, liquid trading conditions to pay off.
Any disruption to Treasury market liquidity therefore could well be amplified by disturbing these players – sending potentially seismic ripples through a market that’s a bedrock for global finance.
STRESS BUILDER
Enter the Iran attacks and an oil spike and there was more than a twitch in the seismograph. Treasuries were rocked by a sudden wipeout of 2026 Fed easing expectations.
For a start, implied volatility of the Treasury market – the three-month MOVE index – rocketed to its highest since last May. The surge is even more alarming – the biggest monthly rise in that volatility gauge since early 2009, shortly after the global banking crash.
But there are even more worrying details.
Wall Street bank Morgan Stanley on Wednesday pointed out that liquidity in short-dated Treasury debt had deteriorated markedly amid the global volatility and dramatic shift in rate expectations triggered by the Iran conflict.
Specifically, the bank examined bid-ask spreads in two-year Treasury notes – effectively the transaction buffer intermediaries charge for bearing any uncertainty – and found they had widened about 0.15 basis point, or almost 30%, during March compared with February.
Yet trading volumes actually surged – and weekly activity in two-year “on-the-run” Treasuries, or new issues, was the highest since the tariff shock last April.
The peculiar confluence of spread widening and high volumes suggests stressed selling, they reckon.
“Wider bid-ask spreads would tend to dissuade trading and the fact that volumes have picked up regardless reflects the idea that many of the trades have been done out of necessity, not desire,” Morgan Stanley concluded.
FORCED SELLERS
That there’s been stressed selling of sorts was reflected in Fed data on Treasuries held in custody on behalf of foreign official entities such as central banks.
This shows a drop of around $75 billion in the last four weeks, which is estimated to equate to some $60 billion of active selling and may well be related to Middle Eastern holdings.
Monday’s poorly received two-year note auction shows that anxiety in the market is lingering and raises a question of whether the volatility is now weighing on demand more broadly.
Repo markets at least appear to have held stable despite the wider turbulence.
But erratic policymaking in Washington – and the uncertainty and market stress it generates- is a combination many fear could yet cause an accident under the bonnet of the financial system.
As global financial stability officials fretted earlier in the month, repeated policy shocks and twists and turns may see many more fragile parts of the financial world crack in the process.
Strains in the Treasury market bear very close watching.
(The opinions expressed here are those of Mike Dolan, a columnist for Reuters.)
Editing by Marguerita Choy
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