The Vulnerabilities of Core Bond Markets in the US Economy

As the economy continues to face severe stresses, it has led to repeated breakdowns in the core markets worldwide. These events have underlined the need for public and private sectors to collaborate and develop tools to mitigate future market dysfunction. Unfortunately, these extreme stresses are becoming increasingly common in the US financial system, which creates holes in the intermediating process between buyers and sellers.

The Importance of Core Bond Markets

Core bond markets are crucial to the economy as they finance the national government, implement monetary policy, offer collateral, and establish a benchmark yield curve that underpins financing for households, businesses, and state and local governments.

The Growing Vulnerability of Core Bond Markets

The supply of intermediation has not kept pace with demand. As a result, the Treasury market’s size and complexity have grown, causing trade breakdowns and price discovery in core markets. These failures result from insufficient intermediation as the range of Treasury debt held by the public rose from 35% of GDP at the end of 2007 to around 95% of GDP in late 2022. Increasing debt shares are held by investors, such as hedge funds and mutual funds, that trade more frequently while relying on the ability to monetize assets quickly when required. Simultaneously, primary dealers – major intermediaries in these markets – have not increased the balance sheet devoted to Treasury holdings nor Treasury repo since 2007. The rise of electronic trading has also shifted intermediation toward principal trading firms that typically hold less capital to absorb shocks, increasing the pace at which market developments establish.

Related Facts

• The Treasury market’s size and complexity have grown as the range of Treasury debt held by the public rose from 35% of GDP at the end of 2007 to around 95% in late 2022.
• Primary dealers who are intermediaries in these markets have not increased the balance sheets devoted to Treasury holdings and Treasury repo since 2007; hence intermediation has not kept pace with demand.
• The rise in electronic trading has shifted intermediation toward principal trading firms that typically hold less capital to absorb shocks.

Key Takeaway

Financial markets must improve their resilience to mitigate the effects of core market dysfunction during economic uncertainties. The public and private sectors must work together to enhance market resilience and ensure that future restructuring of markets will be less frequent. In addition, Central banks must develop the toolkit necessary to minimize dysfunction and be ready to address extreme stressors that threaten financial stability or the macroeconomy.

Conclusion

Financial markets are not unusual to become vulnerable during uncertain economic times. Therefore, the public and private sectors must cooperate to improve market resilience and prevent economic interruptions. In addition, central banks should develop efficient tools to mitigate any future market dysfunction and be ready to address extreme stressors that threaten financial stability.