U.S. regulators have become increasingly concerned in recent
months about unstable trading in the $12.6 trillion U.S. Treasury
market, where investors turn for safe-haven securities and set
interest rates that are a benchmark for much of the rest of the
global financial system.
Investors have complained that trading in large blocks of
Treasurys has become increasingly challenging in recent years and
yields appear prone to occasional lurches, developments that could
become a problem if the Federal Reserve starts raising short-term
interest rates later this year, as is expected.
Regulators are set to release their findings from a review into
conditions in the bond market Monday, including an inquiry into
whether the government itself, because of regulations set in motion
following the 2008 financial crisis, is contributing to the
problem, according to people familiar with the matter.
The review primarily focuses on an Oct. 15 incident known in the
bond industry as a "flash crash," when yields on Treasury bonds
plummeted within minutes, before quickly recovering, these people
said.
The Federal Reserve, the U.S. Treasury Department and the
Securities and Exchange Commission are among those that have been
studying episodic swings like that and complaints that it is
becoming difficult to trade rapidly in large sizes, people familiar
with their discussions said.
The Federal Reserve Bank of New York and the Treasury Department
have analyzed several metrics of recent changes in bond markets,
including problems investors are experiencing trading bonds in
various sizes and the growing role of high-frequency trading in
Treasurys, said the people familiar with the matter.
One key cause for concern, traders say, is that the U.S.
Treasury market is the biggest it has ever been, yet the smallest
slice of bonds on record are changing hands as a percentage of the
market's overall size.
As of last month, it would have taken the equivalent of 25 days
for all available Treasurys to trade, up from eight days a decade
ago, when the market was a third of its current size, according to
data from the Securities Industry and Financial Markets
Association.
The Fed and other regulators are worried that if large Treasury
transactions are taking longer to complete in a selloff, it could
interfere with market stability as the Fed moves to raise interest
rates for the first time in nearly a decade.
While the Fed has carefully telegraphed its intentions to avoid
shocks, "we'd also want to understand the potential impact on the
real economy of any increased difficulty, for example, in moving
large positions," Fed Governor Daniel Tarullo said at a conference
in June.
In the spring of 2013, Treasury yields rose sharply after the
Fed signaled it was contemplating reining in its bond-buying
program, a period that became known as the "taper tantrum." That
September, the Fed delayed an expected cut in its bond buying until
December. After the taper tantrum, the housing market slowed, a
warning sign that dislocations in the bond market—and their effects
on mortgage rates—could have a broader impact on Americans and the
economy. Housing later recovered.
Jerome Powell, another Fed governor, told The Wall Street
Journal last month he "underestimated how significant the move
would be" in Treasury yields around the time of the taper
tantrum.
Partly to blame, Wall Street firms argue, are capital and
leverage rules that have made it more expensive for banks to commit
heavy resources to facilitating bond trades for clients, or have
caused banks to exit parts of the market entirely.
"We do have a challenge out there" for large trade sizes, said
Richie Prager, head of trading and liquidity strategies at asset
manager BlackRock Inc., in an interview Thursday. BlackRock
oversees $4.8 trillion of assets.
BlackRock has advocated for a series of enhancements in trading
of bonds to improve their "liquidity," an amorphous concept on Wall
Street that typically refers to the ease with which investors can
trade large volumes with minimal impact on prices.
Mr. Prager said rules "are partially responsible" for difficult
trading conditions, but acknowledged there were "multiple factors"
driving the changes in bond markets.
Mr. Powell concluded in an interview with the Journal last month
that, while there are a variety of factors roiling trading, "you
have got less depth in bond markets." But he added, "It is not
obvious it is all because of regulation."
Regulators' review of bond markets was cited in the Financial
Stability Oversight Council's annual report, released in May, which
said the regulators would publish an "interagency white paper"
analyzing the events of Oct. 15 and recent changes in the structure
of the bond market.
The dislocations in the bond market could be driven by other
factors as well, including shifts in the makeup of participants in
the markets and a growing adoption of electronic trading.
The rise of algorithmic trading firms has meant trading has
become much faster and lower volumes can contribute to larger
moves. Some of the new speedy traders might be exacerbating gaps in
market depth by pulling away from the market quickly, leading to
discontinuous pricing in Treasurys and higher volatility in
yields.
After a long bull run in the debt market, some fear that
investors have loaded up on bonds as volatility is rising from
historic lows and the Fed is preparing to remove its safety net. An
increase in interest rates diminishes the appeal of existing bonds
issued at lower yields, hurting their prices.
"My fear is that individual investors will see major price
dislocations in bonds for the first time since the crisis, and if
they flee, mutual funds will be forced to sell bonds," said Anthony
Perrotta, head of fixed-income research at Tabb Group, a financial
markets advisory and research firm.
As of May, the capital the top 10 primary dealers allocated to
Treasury trading with clients was down 50% from 2010 levels, Mr.
Perrotta said, based on interviews with those banks. The drop is
partly because of postcrisis rules intended to discourage risk
taking at banks, traders said.
At one point in late January, one of J.P. Morgan Chase &
Co.'s measures of so-called "market depth" in 10-year Treasury
notes, or the amount that could be traded without moving prices,
was half its average over the past five years. That metric has
since improved.
Trying to shift positions when market depth is so restricted is
like "trying to pour a bucket of water through a straw," said Alex
Roever, a rates strategist at J.P. Morgan. "You can only move a
limited amount."
Write to Katy Burne at katy.burne@wsj.com
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