Fed chief warns of future volatility in US bonds market

Jerome Powell urges financial firms to prepare for sudden liquidity slumps, as he unveils report into turbulence of 15 October last year

Corporate investors in US government bonds may need to implement measures to protect themselves from abrupt drops in the market’s liquidity, Federal Reserve governor Jerome Powell has warned.

In a 20 October speech titled The Evolving Structure of US Treasury Markets, Powell outlined to an audience of delegates from the finance industry an extensive post-mortem of 15 October 2014 – when trade in American bonds experienced 24 hours of wild volatility.

Since then, the Fed – together with colleagues at fellow regulators the Securities and Exchange Commission, the Department of Treasury and the Commodity Futures Trading Commission – has been investigating that day’s turbulent events. Their analyses have now been collected in a new, top-level report.

Unveiling the document in his speech, Powell explained to the delegates what its findings could mean for the industry in the long term.

“My discussions with market participants and regulatory colleagues suggest a range of opinions about treasury market liquidity,” he said. “While most market participants perceive some reduction in liquidity, views on the severity of the situation seem to be more mixed.

“Some measures, such as trade size and market depth, have declined, and investors today have to employ increasingly sophisticated strategies to execute larger trades at a good price. Some other measures show no decline in overall market liquidity.”

However, Powell stressed, stakeholders must consider not just the average level of liquidity under normal trading conditions, but the risk that it may now be ”more prone to disappearing at times when it is most needed” – as seemed to be the case on 15 October last year.

“This concern is an important one,” Powell went on. “Because US treasury securities reflect the full faith and credit of our government, they are rightly considered risk-free. But the value of any security, even a US treasury [one], will reflect not just its inherent credit risk, but investors’ faith in the markets where it is traded.

“We need investors to have full faith in the structure and functioning of treasury markets themselves. Treasury markets need to be as safe as the securities that trade on them. Episodes such as 15 October [2014], in which treasury prices fluctuated wildly with no obvious reason, threaten to erode investor confidence. The growing list of similar events in equity and other markets underscores this concern.”

Powell noted: “Confidence in treasury markets helps to support demand for treasury securities and keep our government’s financing costs low. Households and firms, and even foreign governments hold treasury securities as a key form of savings, in no small part because of their trust in their safety and liquidity.

“Financial firms have particular reasons to care about these markets. Many types of financial firms are represented here today, with diverse roles within treasury markets. Since before the financial crisis, one of the driving narratives within financial markets has been the growing demand for safe assets. Many have argued that this demand helped to engender the crisis, as a variety of assets came to be accepted as risk-free when in fact they were anything but that.”

He added: “Treasury bills and bonds are about the only freely tradeable dollar-denominated assets that really can be called safe.

“We have a shared interest in guarding against an outcome where the treasury market becomes a source of stress – rather than a safe haven in times of stress.”

Click here for Powell’s full speech

Download a PDF of the Federal Reserve’s joint investigation into the circumstances behind 15 October 2014

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