What’s Going on in the Bond Market?

U.S. Treasury and Commercial Paper Markets are lacking liquidity.

Business activity has slowed dramatically due to the COVID-19 pandemic and businesses are finding it difficult to get the funding they need for their daily operations, to a great extent because banks have stopped extending lines of credit. As a result, they are selling even safe-haven assets like Treasuries, municipal bonds, and gold.

The selling has been exacerbated by investors using leverage in an effort to amplify returns by arbitraging the yield spread between Treasury bonds and other market instruments, including Treasury futures. The surge of sales, coupled with outflows from fixed income markets, forced the system to absorb a significant amount of bonds in a matter of days. Additionally, dealers are not taking on any market risk, so they are not providing liquidity. Even high quality investment grade corporate and municipal bonds cannot attract a reasonable bid.

The Federal Reserve has responded by flooding the repo market with liquidity. That has eased tensions somewhat. Nevertheless, the liquidity crunch is not over. On March 17, the Federal Reserve announced the establishment of a Primary Dealer Credit Facility, a tool it used during the Great Recession to extend loans to the biggest banks, to improve market functioning.

The Fed has also lowered the discount window rate to 25 basis points, which allows banks to convert risk-bearing assets into reserves with a small haircut, and also provide liquidity directly to large corporations via commercial paper purchases. With these actions in place, bankers’ anxieties over liquidity should begin to ease.

Still, banks are hesitant to extend credit as borrowers face escalating solvency risk—especially by consumers and small- and medium-sized businesses. A solution to this problem will likely be included in the proposed $1 trillion fiscal stimulus. Loan guarantees or state-sponsored loans will help private borrowers.

These actions by the Fed are similar to those taken during 2008 Financial Crisis, and should ultimately help facilitate more orderly trading by helping support the markets’ ability to serve their function as intermediary.

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