Amid frenzied trading over the past week, the $18 trillion U.S. Treasury market showed cracks that raised eyebrows across Wall Street, and finally led the Federal Reserve to announce a range of measures on Sunday night including purchases of hundreds of billions of U.S. government bonds over the coming months.

Market participants say the cost to trade Treasurys with virtually identical terms but which differ in maturities by a few months has diverged sharply last week as traders struggled to buy and sell bonds in a hurry. This worrisome phenomenon underlines how volatility across Wall Street has seen trading volumes for older Treasurys slump even in the U.S. bond-market which is advertised as the deepest and most liquid safe-haven asset in the world.

“I have never seen moves like this in 35 years of trading. I’ve never seen anything like it. At this point, the market will get absolutely exhausted,” said Tom di Galoma, managing director of Treasurys trading at Seaport Global Securities.

See: Fed shifts policies to ease ‘highly unusual disruptions’ in Treasury financing markets

Iceberg

The U.S. Treasury market is much like an iceberg.

The more visible and most widely traded part of the market are newer “on-the-run” securities which are the bonds most recently issued by the U.S. government, but it’s the older “off-the-run” securities that represent the bulk of the $18 trillion market. Much of it is held by fund managers, insurance companies, pension funds, and other investors who buy government bonds to earn a steady stream of income.

After the government sells a new round of bonds to investors, those recently issued securities become the new on-the-run securities, relegating the older issues to so-called off-the-run status.

Though traders have been able to move in and out of on-the-run Treasurys with relative smoothness, it’s the less liquid and much bigger off-the-run portion of the market that has seen a sharp erosion of liquidity. This has led to a sharp widening of the price difference between the two buckets of bonds, know as the basis, in recent sessions.

The surge in trading costs for older off-the-run Treasurys highlights the enormous pressure faced by broker-dealers, the middlemen of the bond-market, who are grappling with the biggest swings in government debt yields in sometimes decades.

“If we can’t price and clear Treasurys in a very efficient manner, the market is going to have broader issues,” said Gregory Faranello, head of AmeriVet Securities.

In calm trading, the difference in prices between newer and older Treasurys is usually slim.

That’s because textbook financial theory imply there should be little to no difference for Treasurys with close-to-identical maturities, and so hedge funds, broker-dealers and other fast-moving traders will try to take advantage and bet that this spread, or basis, will eventually narrow.

For example, a patient trader could short an on-the-run 30-year bond maturing in 30 years and buy an off-the-run 30-year bond that was issued half a year ago. After a few months, the on-the-run bond becomes an off-the-run, losing value and eventually trading in line with the other off-the-run bonds. By doing this, the trader profits from this convergence.

Postcrisis liquidity

During times of intense volatility like this week, dealers, however, will demand a hefty premium to trade off-the-run Treasurys, as it could be difficult to take them onto their balance sheet and offload them again to a willing buyer.

“In the high-speed, high-volume, intense trading in the last few weeks, it’s hard to turn your inventory quickly around,” said Jim Vogel, an interest-rate strategist at FHN Financial.

On the other side, mutual funds and other investors promise their clients that they will be able to pull money in and out of funds on a day-to-day basis. These investors who have seen their off-the-run Treasurys holdings record double-digit gains in the span of a few weeks are now trying to sell their bonds and book profits, said market participants.

This mismatch in demand has led to a surge in the difference between the prices offered by buyers and the prices sellers are willing to accept, or the bid-ask spread, for off-the-run bonds.

“The market might clear. You just won’t like the price,” said Susan Estes, president and chief executive of OpenDoor Securities, a trading platform for off-the-run Treasurys, and a former member of the Treasury Borrowing Advisory Committee.

Investors say the lack of liquidity has also been compounded by changes in the overall bond market’s infrastructure since the financial crisis.

The consolidation of banks in the aftermath of 2008 means the bond market is now relying on a narrower group of broker-dealers to connect market participants who want to buy and sell their bonds. In addition, dealers have been saddled with post-crisis regulations that mean they cannot lever up their balance sheet to trade at a much larger capacity like they could in the past.

“Pre-crisis, on-the-runs and off-the-runs were indistinguishable as pools of liquidity,” said Estes.

Di Galoma says the bid-ask spread for an off-the-run 10-year note was as high as 50 basis points on Thursday. In other words, to sell $1 million of such notes, investors would have to give up $5,000 of the overall transaction’s value to complete the trade.

Bid-ask spreads for the 10-year note TMUBMUSD05Y, 0.272% would usually stand at around a single to a few basis points.

In the context of the hundreds of billions worth of bonds changing hands every day, trading costs can thus head into the millions of dollars. For example, close to $5.7 trillion worth of Treasurys were traded in last week alone, according to the Financial Industry Regulatory Authority.

“You couldn’t trade off-the-run Treasurys even if you begged people,” said Gang Hu, managing director of WinShore Capital Management, a fixed-income hedge fund.

Faranello concurred. On Monday, there were times when traders could not find anyone willing to sell off-the-run 30-year bonds, a rare occasion in the most liquid financial asset in the world, he said.

At the end of the day, the 30-year bond yield TMUBMUSD30Y, 1.409% had booked the biggest back-to-back decline since October 1987, the month of the Black Monday stock market crash.

Funding strains?

Trading costs for off-the-run Treasurys tend to blow up when strains arise in short-term funding markets as they did when the 1998 implosion of the hedge fund Long-Term Capital Management, which had borrowed from short-term funding markets to scale up its billion-dollar wagers on bond-market spreads such as those between older and newer Treasurys to narrow.

In 1998 a lack of illiquidity amid worries over financial crises in Europe and emerging markets saw demand for the most liquid on-the-run Treasurys soar and appetite for off-the-run bonds dwindle.

This blew up the price difference between the two buckets of bonds, forcing LTCM to unwind and liquidate its positions, and freezing funding markets as banks realized one of their biggest borrowers was at the risk of collapsing.

Read: New York Fed to add liquidity into short-term markets unsettled by coronavirus

But market participants say the recent blow-out of bid-ask spreads for older Treasurys is not so much a reflection of funding pressures, and more a reflection of how dealers were struggling to handle unprecedented daily volatility in the bond-market.

It’s why Priya Misra, global head of rates strategy at TD Securities, in an interview with Bloomberg Television said the Fed’s repo liquidity injections would not help smooth dislocations in the Treasury market.

The U.S. central bank offered up $1.5 trillion of funds through longer-term repurchasing operations this week, in which it lends short-term funds to designated broker-dealers in return for collateral such sa Treasurys. The take-up of the operation was, however, limited.

Investors also point out funding costs have remained contained.

At the start of Tuesday, market participants could borrow in overnight repo markets at 10 to 15 basis points above the Federal Reserve’s benchmark interest rate, or around 1.2%, said Hu. That same session saw the biggest rally in the 10-year benchmark Treasury note since 2009.

This compared with the seizure in funding markets last September which saw overnight borrowing costs jump to as high as 10%.

Stepping in

Indeed, the Fed appears to be switching tack.

Beyond increasing the size and maturity of its repurchasing operations, the New York Fed said Thursday the $60 billion of bonds it was scheduled to buy from mid-March to mid-April would not only target short-term Treasury bills, but government bonds across all maturities.

Analysts say this tweak is targeted directly at easing the lack of liquidity in off-the-run Treasurys, as the Fed’s purchases of longer-term bonds would target older issuance not newer debt, wrote Kathy Bostjancic, chief U.S. financial economist at Oxford Economics.

And on Sunday, the U.S. central bank said it would buy at $500 billion in Treasury securities and $200 billion in mortgage-backed securities over the coming months, beginning on Monday. Investors said these purchases are likely to be aimed at the off-the-run bond market.

Treasury issuance

Investors say the lack of liquidity in the off-the-run Treasurys shines a light on the workings of financial markets, at a time when it could come under increased pressure in the coming months as the coronavirus epidemic impacts economies and markets.

In markets, the S&P 500 SPX, -2.37% and the Nasdaq Composite COMP, -3.01% entered a bear market on Thursday, joining the blue-chip Dow Jones Industrial Average DJIA, -1.92% , which ended its eleven year long bull market on Wednesday. A bear market is widely defined as a 20% drop from a recent peak.

As the U.S. Treasury Department ramps up bond issuance to accommodate the government’s bulging fiscal deficits, the amount of new debt issuance that cascades into the pool of older off-the-run bonds will increase with every year.

“The off-the-run market has become more and more critical, the U.S. is issuing more and more debt,” said Faranello.

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