Part One: How safe are 'risk‑free' investments?

Part One: How safe are 'risk‑free' investments?

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By Krzysztof Rojek, Senior Director of Global Solution Consulting at Finastra

Safe haven investments, such as long‑term government debt, have historically been considered low‑risk market opportunities, delivering nearly certain returns with little possibility for loss. Among the most well-regarded assets are G7 bonds, debt instruments backed by some of the world’s largest industrialised nations.

But exploring the history of the bond market reveals some startling trends in the liquidity of bonds, such as US Treasuries, and underscores the need for stability in this market.

Demand for government bonds escalated over the last decade as investors from all walks of life sought the relative guaranteed security in the market. The US bond market alone had ballooned to $24 trillion (£18.8tn) by late 2022, representing a quarter of world’s GDP.

Growth projections for the future, however, could be offset by a simple matter of liquidity, the market’s ability to quickly sell assets without causing drastic changes in price. In early 2020, at the start of the COVID‑19 pandemic, US Treasuries’ liquidity dropped sharply as no one knew what to expect when the lockdowns began. By mid‑year, the market saw a rapid rally as the Fed began purchasing treasuries, but soon dropped again as quickly as it spiked. In uncharacteristic fashion, liquidity has since tightened precipitously, ending 2022 at near pandemic levels as well as those witnessed at the peak of the Great Financial Crisis. Liquidity has so far improved in 2023, but the events of 2022 are a reminder of how quickly the sentiment can change.

What’s disrupting bond market liquidity?

Under normal conditions, liquidity in the bond market can be derailed when there is an imbalance between the number of buyers and sellers, and is quickly resolved given the sheer size of the market. Current disruption, however, was spurred on by a unique combination of factors that could easily upset bank and investor balance sheets in the years to come. Interest rate hikes have a direct impact on government bonds, usually causing prices to fall and yields to rise as it’s more costly to fund long bond positions.

Another possible outcome  of continuing hikes, as we have seen recently, is an inverted yield curve, where bonds with shorter tenors yield higher returns than those with longer. An inverted yield curve can reduce liquidity in the market by shifting investor demand to short‑term bonds and bills, and away from the benchmark long‑term bonds, a particularly troubling outcome for the present, given the Fed’s quantitative tightening.

From March 2022 through to May 2023, the Federal Reserve Bank has hiked rates a total of 500 basis points in an attempt to calm inflation. Although the Fed paused in June, it raised rates again in July, and the ECB and the BoE have continued to raise their benchmark interest rates in 2023 defying bond market expectations.

As the Fed attempts to reduce the number of bond assets cluttering its balance sheet by $95 billion a month, it’s letting bond holdings run off as they mature, in a process called quantitative tightening. However, many economic experts believe the policy will lead to greater market volatility and even lower liquidity across bond markets, particularly in light of the fact that Japan has also drawn back on purchases of US Treasuries, and perhaps even sold some of its holdings to fund its yen interventions.

Economic experts largely agree that major central banks, like the Federal Reserve, are drawing too much liquidity out of financial markets too quickly, a precarious situation to be in when those who traditionally used to be the biggest buyers are nowhere to be found.

Quantitative tightening in a high inflation environment is untested

One of the biggest challenges facing world markets today is the unknown. The current unwinding of the Fed’s balance sheet, coupled with rising inflation and the war in Ukraine, is a combination unprecedented in modern markets. With few historical patterns to inform future predictions, it’s hard to determine the upcoming impact to bond yields and pricing. It’s a situation where a lack of precedent, combined with future uncertainty, will result in high volatility and low bond market liquidity. To offset the mounting economic upheaval, many experts believe that central banks will continue to battle inflation by raising interest rates until something breaks. That could easily be the bond market.

But why are Treasuries and other bonds so vulnerable to the current round of stressors? The main reason is lack of transparency.

Unlike equity markets, Treasury markets are predominantly conducted through bilateral over the counter (OTC) transactions, often in hundreds of millions of dollars per ticket, that do not always have to be reported. Adding to the opacity, a much bigger share of the market has gone to less regulated non-banking participants in recent years, such as pension funds, insurance and private equity companies. OTC derivatives, like interest rate swaps, carry combined market risk exposure that eclipses even the biggest government bond market. As a result, it’s hard to assess where pools of leverage reside and how big they are.

In part two of this article I will explore how uncertainty is impacting the market and the instability caused by the volatility of treasury bonds.

To be continued on August 16

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