As Federal Reserve officials look to raise interest rates for the first time since 2006, they are studying changes in the $12.7 trillion Treasury market and are worried about what they don’t know.
Officials are concerned that shifts in market structure have contributed to episodes of unusual volatility. Exhibit A: a sudden surge in bond prices on Oct. 15 that drove the biggest drop in yields for 10-year notes since 2009.
Such incidents are of particular concern to central bankers already worried that raising their benchmark interest rate will push bond yields higher than they would like, putting the fragile economic expansion at risk. Changes in market structure could amplify the reaction.
“They want to do a controlled tightening of financial conditions,” said Guy Berger, an economist at RBS Securities Inc. in Stamford, Connecticut. “They just don’t want to cause some sort of event that they can’t quickly reverse.”
Fed officials, who meet for two days next week, aren’t likely to raise rates before September, according to a Bloomberg survey of economists. They will issue new forecasts for the economy and the path of the federal funds rate, and Chair Janet Yellen will give a press conference after the meeting.
“There have been a few episodes in recent months of sharp spikes in volatility, in some cases associated with big news, big policy news, in some cases really not,” Fed Governor Lael Brainard said at an event in Washington on June 2. The Fed is “looking very carefully at what might be contributing to this more volatile -- or at least spikier -- set of events.”
At their last meeting in April, officials expressed concern that raising the benchmark rate could prompt a jump in yields reminiscent of the so-called taper tantrum of 2013, minutes of the gathering show. The rate has been kept close to zero since December 2008.
Officials in April linked greater volatility with changes in market structure, including the increased role of high-frequency traders.
In the taper tantrum, markets gyrated after then-Chairman Ben S. Bernanke suggested the Fed could start trimming a bond-buying program sooner than anticipated. Recent rockiness, such as the Oct. 15 incident, has been harder to explain.
Brainard said the Fed is studying the “notable shift” to a larger number of participants in some markets and an increasingly dominant role for electronic, algorithmic, and high-frequency trading.
Coincidentally, the Justice Department has begun an examination of trading in the Treasury market, following the outlines of its successful cases against Wall Street’s illegal practices in foreign currencies and other businesses, according to three people familiar with the inquiry.
The share of transactions by primary dealers, the U.S. government’s most important counterparties in the Treasury market, has dropped by more than half to 4 percent since the end of 2008, according to the Institute of International Finance in Washington.
Some of the change in market structure may be in response to heightened regulation of banks in the wake of the 2008 financial crisis. For instance, big banks are scaling back bond-trading business to comply with higher capital requirements imposed by Basel III that went into effect this year, and some fund managers say the Dodd-Frank Act’s Volcker Rule is hurting liquidity.
As the banks step back, investors have been trading more derivatives. Trading of Treasury note futures, for example, has risen 46 percent over the past five years, based on first-quarter volumes. Derivatives strategies can magnify any gains or losses that occur and may contribute to volatility.
What’s more, electronic trading is becoming more prevalent. Last year, it made up about 50 percent of the Treasury market, according to a report from research firm TABB Group. If electronic trading algorithms are all set to respond similarly to the same market event, that could result in liquidity drying up very quickly.
“We’re certainly devoting resources to trying to understand” what is happening with market liquidity, Fed Governor Daniel Tarullo said in a June 4 speech in New York. The Fed is trying “to understand what, if any, effects we can expect on the real economy, and then to ask the question -- should something be done about it?”
The Financial Stability Oversight Council, which is charged with monitoring threats to the financial system, is still studying what caused the Oct. 15 scramble.
Member agencies will publish a white paper in coming weeks assessing what happened, according to FSOC’s annual report, released last month. FSOC’s members include the Treasury, the Fed and the Securities and Exchange Commission.
No Good Grasp
“There’s something going on that we don’t have a good grasp on yet,” said Mo Grimeh, 48, who runs a desk of 80 traders and sales staff at Standard Chartered Bank in New York, operating mostly in emerging-market currencies, credit and rates. Fed rate increases “will only exacerbate those spikes.”
Understanding why markets may be more prone to swings matters for the Fed because Treasury yields affect borrowing costs on everything from autos to houses.
While Treasury yields rebounded swiftly after the Oct. 15 drop, it will be hard for policy makers to judge whether another bout of severe volatility would play out along similar lines, said Berger of RBS.
“They have no idea, when that kind of thing is happening, how long it’s going to stay,” he said. “It makes you more jittery around those events.”