Will Treasury Bond Volatility Bring Back the Fed?

Will Treasury Bond Volatility Bring Back The Fed?

It has been an unusual two years in the bond market and the steady hands who had once maintained calm over U.S. Treasury yields are less present than before, leaving more price-conscious, and often shorter-term buyers such as hedge funds, mutual funds, and pension funds to control the market.

In this latest edition of LPL Street View, LPL Chief Investment Officer Marc Zabicki takes a brief look at why Treasury yields are more volatile and why the Federal Reserve (Fed) may have to step back in as a buyer of Treasuries in order to stem volatility that is at risk of upsetting financial stability.

Federal Reserve:  A Dual Mandate….Plus

The U.S. Fed is responsible for achieving  1.) stable prices and 2.) maximum sustainable employment, the two elements of its dual mandate.  However, the Fed is also responsible for upholding a degree of financial stability that is a necessary foundation of a sustainable economy.  And today, financial stability has been impaired by unusually wide swings in Treasury yields. These swings have increased financial instability because they effect interest rates on which businesses and consumers make economic decisions.  We know this because in the Fed’s October Financial Stability Report members called out low liquidity in the Treasury market and commented on the potential negative impact on funding markets.

Why Are Treasury Yield and Bond Prices More Volatile?

There are indeed a few reasons why the Treasury market is more volatile today:  1.) The Fed is no longer as prominent in the market as it once was,  2.) The larger amount of government debt has caused a current supply/demand imbalance, a problem that could get worse given the expected debt trajectory, 3. Commercial banks are also not as prominent in the market given the leverage requirements of the Dodd Frank Act, and finally, 4.) with the Fed and Commercial banks stepping back, the Treasury market is now in the hands of more price conscious, short-term buyers.

To Stem the Rise in Volatility, We Believe Two or Three Things Need to Happen

There are no easy remedies to reduce the level of Treasury volatility, steady interest rates, and help maintain financial stability.  However, we believe at least one and perhaps two of the next three things need to happen:  1.) policymakers need to recalibrate the Dodd-Frank Act to allow commercial banks more flexibility to invest in the Treasury market, 2.) policymakers will need to reduce the U.S. government’s level of deficit spending, and, finally, 3.) should policymakers fail to act on items #1 and #2, then the Fed will need to again increase its level of Treasury bond buying.  While the latter, unfortunately, may be the most likely scenario it is clear to us that fiscal and/or monetary policymakers will need to do something to bring more order to this market.

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