Troubles Percolate in the Plumbing of Wall Street

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.

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.

“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.”

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.

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.

“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.

“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.”

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.

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, breaking down perhaps the most basic relationship in markets.

“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.

“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.”

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.

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.

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 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.

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 led to technological breakdowns.

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.

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.

“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.”

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.

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.

“It’s crunchtime, and the balance sheet just isn’t there,” Mr. Goldberg said.

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.”

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