In response to a deterioration in liquidity and functioning of the market for U.S. Treasuries, the New York Fed announced Thursday (12 March) that it would 1) alter the maturity distribution of the currently scheduled reserve management purchases and 2) provide larger and longer-term loans to primary dealers. And depending on conditions in broader markets, the Federal Reserve may prepare for further actions to support markets and the economy.
In a blog posted earlier this week (“When Rate Cuts and Quantitative Easing Fall Flat”), we warned of possible further stress in markets, and discussed whether and how the Fed could respond with targeted programs. In Thursday’s announcement, the Fed did just that.
Responding to Treasury market liquidity challenges
Over the last few days, Treasury market liquidity was strained as a rise in broader market volatility prompted a wave of sales in off-the-run Treasury bonds. These sales were largely driven by investors who use leverage in an effort to amplify the returns of arbitraging the yield spread between Treasury bond yields and other market instruments, including Treasury futures. This wave of sales coupled with general investor outflows from fixed income markets forced the system to absorb a significant amount of bonds in a matter of days.
The Fed’s actions Thursday should ultimately help facilitate more orderly trading as these large positions are liquidated. By providing primary dealers with term loans, and increasing the Fed’s own purchases of off-the-run Treasury bonds, the Fed is helping support markets’ ability to serve their intermediary function.
However, these actions ultimately may not be enough. Trading conditions in other markets are also strained. For example, the yield spread of agency mortgage-backed securities (MBS) to the 10-year Treasury is at its widest level since the 2008 financial crisis, according to Bloomberg, suggesting that pressures in that market are hindering the effective transmission of monetary policy.
Furthermore, the issues in the Treasury market may be a preview of broader market strains as businesses and consumers come under more severe duress from COVID-19-related disruptions, and credit fundamentals deteriorate.
Under these conditions, the Fed could announce a mix of targeted policies to support markets and more general actions to ease monetary policy and financial conditions to support the economy.
We think it’s likely that the Fed cuts the fed funds policy rate to zero, and confirms that they will do whatever it takes to support markets. And to further ease financial conditions, the Fed could announce broader plans to purchase assets, including MBS, while also emphasizing that it stands ready to initiate targeted support to markets as needed in the event of further stress.
For more on our outlook on interest rates, monetary policy, and the investment implications, please see “What’s Next for Interest Rates?”
Tiffany Wilding is a PIMCO economist focusing on North America. Rick Chan is a portfolio manager focusing on global macro strategies and relative value trading in interest rates. Both are contributors to the PIMCO Blog.