Biggest Risk to Stocks Since 2007 Is Declining Liquidity in Treasuries: BofA

  • The decline in liquidity in the US Treasury market represents the biggest systemic risk for financial markets, according to Bank of America.
  • The risk of falling liquidity and resilience of US Treasuries could be greater than the 2007 housing bubble, BofA said.
  • “While this sounds like a bad sci-fi movie, it is unfortunately a real threat,” BofA said.

The decline in liquidity in the US Treasury bond market represents the largest systemic risk to financial markets since the 2007 housing bubbleif not bigger.

That’s according to a Wednesday note from Bank of America, which outlined how important the day-to-day running of the US Treasury market is and how imperative it is that the market runs smoothly.

“The US Treasury market is the most important financial market in the world, as Treasury rates are a critical benchmark for pricing virtually all other financial assets,” the G30 said in a report. July 2021, adding that confidence in the US Treasury market is essential to the stability of the global financial system.

But trouble brewing in the US Treasury market, as the total amount of capital allocated to market making has not kept pace with the rapid growth of outstanding Treasury marketable debt. As trading in the US Treasury market declines, while US Treasury bond issuance increases, a period of illiquidity could materialize.

“If the Treasury market fails to trade for a period of time, the various credit channels, including corporate, domestic and government lending in securities and loans, are likely to cease. This could lead to events such as a US government default. If the auctions don’t, don’t proceed… It’s hard to conceive of spillover effects on the dollar, stock markets, emerging markets, consumer and business confidence,” BofA said.

The spillover effects would be massive if it were anything other than the 2007 housing bubble burst, which led to widespread job losses, foreclosures and deep global financial losses as liquidity in the housing market plummeted.

“While this sounds like a bad science fiction movie, unfortunately it is a real threat that has absorbed a large number of person-hours over the last 10 years with very little output from regulators or lawmakers,” the bank added.

Liquidity concerns in the Treasury market come as the Federal Reserve begins to withdraw as a big buyer of fixed-income securities. The central bank is increasing its monthly balance sheet to $95 billion in September. the central bank has about $9 trillion in assets on its balance sheet, made up of US Treasury bonds and mortgage-backed securities.

And while the Fed has stepped in to buy US Treasuries during periods of market stress, it’s a “long-term tenuous solution for the central bank to act as buyer of last resort for federal debt,” he said. BofA.

“It is not structurally sound for US government debt to become increasingly dependent on Fed QE,” BofA said. “In our view, it’s risky to rely on the Fed alone to solve the problem of Treasury market liquidity, resilience and performance.”

Instead, BofA believes that a better long-term solution is to create a dealer of last resort other than the Federal Reserve, which abides by its dual mandates of price stability and low unemployment.

“We believe that such an entity should be formed before a crisis requires it. A broker of last resort could create markets in a wide range of securities in cash, futures, swaps, stocks, bonds, currencies, commodities, such as The big international brokers do it today,” BofA said, adding that it should be structured as a government-sponsored company.

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