The incident in the UK was born out of a unique combination of bad politics and leveraged funding. Former Prime Minister Liz Truss’ massive fiscal stimulus package caused UK government bond yields to rise sharply, triggering huge demands for collateral on UK pension funds that had accumulated exposures to derivatives linked to long gilts. When funds sold bonds to raise cash, it drove yields even higher, generating more collateral calls and creating a vicious circle than only the Bank of England’s emergency intervention and reversal of Truss’ policy could stop.
I see two reasons why the United States is unlikely to experience anything similar. First, the US president lacks the power of the UK prime minister to implement controversial policy, especially with the Senate evenly divided along party lines. If the Biden administration proposed what the Truss administration did, US Treasury yields would barely budge because no one would reasonably expect the plan to become law.
Second, US pension funds don’t use the leveraged strategies that have caused problems for their UK counterparts as much. They also make up a smaller part of the U.S. financial sector, thanks to the country’s long-term shift from defined-benefit pension plans to defined-contribution plans such as 401(k)s. So even if Treasury yields jumped, the ripple effects would be less.
That said, wreaking havoc on the Treasury market is not impossible. Just a few years ago, the onset of the coronavirus pandemic triggered a global “money rush” that severely destabilized the market and forced the Fed to intervene. Therefore, it is worth taking steps to make the US Treasury market more resilient.
Good ideas abound. The introduction of more centralized clearing of Treasury trades could help, allowing more investors to trade directly with each other and reducing counterparty risk and the market’s dependence on a small group of brokers. More public reporting of trade would increase transparency, reducing uncertainty and risk. But such reforms will take time, as they may require new infrastructure and involve consensus building among regulators and market players with differing goals and perspectives.
In the meantime, the Fed can take a helpful step: provide supportive funding to all Treasury holders, ensuring they can borrow money against the securities whenever needed. The central bank has already made such a permanent repo facility available to a select group of primary dealers and commercial banks. To broaden access, the Fed need only allow primary dealers to transfer Treasuries and cash to and from their customers through this facility – and, importantly, separate those transactions from dealer regulatory balance sheets, so that such (riskless) activities do not generate higher capital requirements. To protect against losses, the Fed could implement a conservative margin regime, i.e. limit the amount it will lend against a given amount of Treasury collateral, with higher haircuts for longer maturities. long, where prices are more sensitive to interest rates. changes.
With such a facility in place, anyone buying a US Treasury security would also have the right to turn it into cash, at any time, with the Fed. Such a liquidity feature would both enhance market resilience and make Treasuries more attractive, leading to lower borrowing costs for the US government. In other words, it would be a win for investors, for US taxpayers, and for the entire financial system.
More from Bloomberg Opinion:
• The next Fed crisis is brewing in Treasuries: Robert Burgess
The world’s largest market still needs some work: editorial
• The US Treasury market needs more than just clearing: Paul J. Davies
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Bill Dudley is a Bloomberg Opinion columnist and senior advisor to Bloomberg Economics. A senior researcher at Princeton University, he was president of the Federal Reserve Bank of New York and vice-chairman of the Federal Open Market Committee.
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