(Bloomberg) -- The Treasury market has been rendered structurally unstable by its explosive growth and is likely to require occasional "official interventions" to support its functioning, according to strategists at Barclays.
The $31 trillion US government debt market "has grown far faster than the quantum of bank capital," creating a gap between the supply and demand for liquidity that reverses a decades-long trend and is "the underlying force driving market fragility," according to a March 30 report by New York University finance professor Jeffrey Meli and several of his former colleagues at Barclays.
The Treasury market has grown at a rate of nearly 9% since 2009, faster than over the previous two decades. Bank capital, meanwhile, expanded by an average of 3.8% a year since 2019, less than half its rate over the preceding period, according to the report co-authored by Barclays strategists Samuel Earl, Anshul Pradhan and Amrut Nashikkar. The bank capital calculation uses quarterly Federal Deposit Insurance Corp. data.
"This imbalance increases the need for official interventions to stabilize markets during periods of volatility," the team wrote. The result is "a vicious cycle: expectations of intervention can become self-reinforcing if they result in greater use of leverage and, thus, more risk of disorderly unwinds."
Meli left Barclays for academia last year and remains a consultant to the bank.
Official interventions in the Treasury market have become a common feature of the landscape since the 2008 financial crisis, taking the form of large-scale buying of securities by the Federal Reserve. The largest of those followed the onset of Covid in 2020, when Fed buying of Treasuries to meet a sudden demand for cash in the financial system caused its holdings to balloon to nearly $5 trillion in 2022 from around $2 trillion in early 2020.
The Treasury market's growth is a function of the size of federal budget deficits requiring financing. The slowdown in bank capital growth, the report says, appears to be a consequence of post-crisis reforms that reduced banks' average return on equity.
Other manifestations of the market growing faster than bank capital include broad cheapening of Treasuries relative to interest-rate swaps. They also include the collapse since the financial crisis in the share of Treasury auctions awarded to so-called primary dealers.
The Treasury market can endure occasional bouts of instability, however the tolerance for them has declined over the past decade because "the entire liquidity pillar of the new regulatory regime is built on the presumption that the Treasury market will remain liquid, even during periods of broader economic and financial distress," the report says.
From that standpoint, "the stability of the market can be considered a liability of the Federal Reserve."
The liquidity imbalance in Treasuries means "it is not possible to have stable markets, stable intermediaries, and avoid bailouts," the report concludes. "A credible commitment to avoid market interventions would increase the preference for reserves and exacerbate banks' unwillingness to extend balance sheet during periods of stress."
More stories like this are available on bloomberg.com
