Malfunctioning financial markets risk undermining the effectiveness of the Federal Reserve’s monetary tightening tools, a top official at the US central bank has warned, as calls grow for sweeping reforms to the $24tn Treasury market.
Speaking at an annual Treasury market conference on Wednesday, John Williams, president of the New York Fed, underscored the need for the central bank to press ahead with its aggressive efforts to tame historically high inflation — which have included aggressive interest rate increases and a rapid wind-down of its roughly $8tn balance sheet — while simultaneously finding solutions to strengthen the resiliency of the financial system.
“For monetary policy to be most effective, financial markets must function properly,” he said. “Monetary policy influences the economy by affecting financial conditions, with the Treasury market at the centre of it all. If the Treasury market isn’t functioning well, it can impede the transmission of monetary policy to the economy.”
He added: “The time is now to find solutions that strengthen our financial system without compromising our monetary policy goals.”
His comments come at a tenuous time for the world’s most important bond market. Liquidity, or the ease with which traders can buy and sell bonds, has materially deteriorated as the Fed has aggressively tightened monetary policy this year in order to rein in inflation.
Treasury yields move with interest rate policy, and the volatile action in yields this year, along with the uncertainty about the Fed’s future path, has made it harder and more expensive to buy and sell bonds. The concern is that poor liquidity could lead to even more pronounced market volatility, increasing the odds of a financial accident.
Further undermining the functioning of the Treasury market, from which all securities are priced, is a set of longstanding structural shortcomings that have meant that shocks in what should be a global safe haven have become commonplace.
That has prompted repeated calls for a regulatory overhaul — something the Fed, the Treasury department, the Securities and Exchange Commission and the Commodity Futures Trading Commission have sought to advance since a “flash crash” in 2014 in which prices across all maturities whipsawed dramatically.
The fragility of the market was most recently exposed in March 2020 when pandemic fears ignited a chaotic dash-for-cash that sent prices whipsawing. That made it almost impossible to trade, with brokers’ screens at times going blank as liquidity evaporated, and the Fed was forced to intervene.
Williams on Wednesday acknowledged that both the size of the Treasury market has dramatically increased in recent decades and that market participants that were once major players have retreated, which has contributed to past market shocks, previous research has shown.
Primary dealers, the banks that buy bonds directly from the Treasury and were historically the leading players in the market, have pulled back since post-crisis regulation passed in 2010 made it more expensive for them to hold bonds on their balance sheets. High-speed traders and hedge funds have since stepped in to take their place, but have operated differently than the banks once did.
Williams on Wednesday called on the private sector to do its part to help to “enhance” the resiliency of the market. “[That] means planning to build resiliency for episodes of volatility that can impair market liquidity, and preparing for periods that have less certain funding, such as at year-end,” he said. “And it means being a source of strength to the financial system and the economy, not a weak link.”
The Fed has in recent years introduced new tools to bolster the government bond market, including two permanent facilities that allow certain domestic and foreign investors to swap their Treasury holdings for cash. In the past two years, regulators have proposed a series of reforms that would improve transparency in the market and bring hedge funds and high-speed traders under regulatory scrutiny.
