The recent turmoil in the U.K. government bond market, which for a moment seemed on the brink of triggering a broader financial meltdown, has some people wondering: Could something similar happen in the much larger U.S. Treasury market, with greater repercussions?
Unlikely. But U.S. authorities can take steps to make such an outcome even more remote.
The U.K. incident arose from a unique combination of bad policy and leveraged finance. Former Prime Minister Liz Truss’s massive fiscal stimulus plan provoked a sharp increase in the yields on U.K. government bonds, which triggered huge collateral demands on U.K. pension funds that had amassed derivative exposures tied to long gilts. When the funds sold bonds to raise cash, this pushed yields up further, generating more collateral calls and creating a vicious circle that only the Bank of England’s emergency intervention and Truss’s policy reversal could arrest.
I see two reasons the U.S. is unlikely to experience something similar. First, the U.S. president lacks the U.K. prime minister’s power to implement controversial policy, particularly with the Senate divided equally along party lines. If the Biden administration proposed what the Truss government did, yields on U.S. Treasury securities would barely move, because no one would reasonably expect the plan to become law.
Second, U.S. pension funds don’t make as much use of the leveraged strategies that got their U.K. counterparts into trouble. They’re also a smaller part of the U.S. financial sector, thanks to the country’s long-term shift away from defined-benefit pension plans to defined-contribution plans such as 401(k)s. So even if Treasury yields did jump, the knock-on effects would be smaller.
That said, havoc in the Treasury market isn’t impossible. Just a few years ago, the onset of the coronavirus pandemic triggered a global “dash to cash” that severely destabilized the market and forced the Fed to intervene. Hence, it’s worth taking steps to make the U.S. Treasury market more resilient.
There’s no shortage of good ideas. Establishing more central clearing of Treasury transactions could help, by allowing more investors to trade directly with one another and by reducing counterparty risk and the market’s dependence on a small group of dealers. More public trade reporting would increase transparency, reducing uncertainty and risk. But such reforms will take time, because they may require new infrastructure and entail consensus-building among regulators and market participants with divergent goals and perspectives.
With such a facility in place, anyone who purchased a U.S. Treasury security would also gain the right to turn it into cash, at any time, at the Fed. Such a liquidity feature would both enhance the market’s resilience and make Treasuries more attractive, resulting in lower borrowing costs for the U.S. government. In other words, it would be a win for investors, for U.S. taxpayers and for the entire financial system.
Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
This article was provided by Bloomberg News.