BOE response highlights ‘impossible trinity’ of liquidity issues


The Bank of England’s pledge of unlimited long-dated bond purchases is a signal UK policy makers are attuned to what Bank of America has called the “impossible trinity” of structural problems plaguing global interest-rate markets.

Mark Cabana, head of US interest rates strategy at Bank of America Corp, said last week there’s a series of underlying issues impacting markets, from high debt loads to restrictive regulation and the absence of central bank intervention. It’s these dilemmas that ultimately forced the BOE to announce its plan to buy bonds, which had an immediate impact on the gilt market, putting yields on 30-year debt on track for the biggest drop on record on Wednesday.

The turmoil in the UK is a reminder that conditions in the global interest-rate market are just as precarious, with the $24 trillion US Treasury market being the prime example. The Bloomberg US Government Securities Liquidity Index — a gauge of deviations in yields from a fair-value model — is near the highest levels since the early days of the pandemic.

Global interest rates repriced sharply and most curves flattened as central banks around the world have begun shrinking their balance sheets, reversing trillions of dollars of pandemic-driven expansion, at the same time they tighten policy. The Federal Reserve has been undergoing so-called quantitative tightening since June, while the BOE was expected to start actively selling its existing holdings of bonds Monday, though it has since delayed the program.

The poor liquidity and increased volatility had sidelined investors at Treasury’s two- and five-year auctions. JPMorgan strategists said Wednesday’s seven-year sale would be difficult to digest given market volatility and declining liquidity over recent sessions, though buyers showed up for the offering.

There are steps the Fed can revisit to help improve Treasury market functioning. When liquidity was precarious at the onset of the pandemic, the central bank exempted reserve balances and Treasuries from the supplementary leverage ratio calculation. The exemption, aimed at improving dealers’ ability to make markets during the stressful period, expired in March 2021, but the central bank has pledged it would propose changes to the rule.

Policy makers are also confident the Standing Repo Facility, which was officially introduced in July 2021, will help keep the Treasury market functioning smoothly. This would allow participants to give the central bank their Treasuries in exchange for cash reserves, though the daily operations are rarely used at this point.

Treasury Secretary Janet Yellen said Tuesday financial markets are functioning well, noting that she hasn’t seen any liquidity problems that could indicate financial stability risks.

Yet Cabana isn’t convinced and fears markets are trading a lot more like March 2020, just without the policy backstop, which in the end will require more intervention.

“Rates do not work as a hedge when risk taking is cut and liquidity is thin,” Cabana wrote in a note to clients. “We are increasingly concerned rates markets will require more frequent CB intervention to stay liquid.”

© 2022 Bloomberg

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