Fixing the plumbing 修管道
A well-functioning Treasury market is crucial—whoever is in the White House. Time to fix how it works
THIS HAS been an extraordinary year for American government debt. The Treasury market is usually the world’s most liquid bond market and a haven in stormy times. But in March it seized up as panic about the pandemic led to fire sales and failed trades. The Fed fixed the problem by buying, in two months, nearly as many Treasuries as it did during five years of quantitative easing after the global financial crisis. The market is now being drenched with new issuance as the federal government spends like mad. Since the start of April it has raised a net $3.3trn to fund its stimulus programmes, expanding the outstanding stock of bonds by 19%. Over the past week bond yields have seesawed as investors have weighed and reweighed the likelihood of more stimulus after the election.
An even more extraordinary decade lies ahead. Regardless of whether a big stimulus is passed in 2021, the budget deficit will probably stay above 8% of GDP. An ageing population will continue to lift health-care spending. And with the Federal Reserve unable to cut rates much more, bigger deficits might be necessary to stimulate the economy during future downturns. A supersized bond market will amplify both the probability of more market stress and its consequences. Randal Quarles, the vice-chairman of the Fed, recently warned that the “sheer volume” of issuance means the market’s plumbing may come under strain. That could disrupt the government’s ability to borrow and cause tremors across the world’s financial system.
There are two fault lines. When Uncle Sam issues debt a group of middlemen known as “primary dealers”—mostly banks—are obliged to buy it up at “reasonably competitive” prices. Primary dealers also act as intermediaries for investors who wish to trade with one another. In a crunch Treasuries can pile up on dealers’ balance-sheets, causing them to swell and pushing the banks closer to breaching the capital requirements set by regulators. That makes it harder for them to act as intermediaries, and investors do not like trading without a big institution sitting in the middle. In the spring, as investors rushed to unwind their bets, primary dealers were overwhelmed.
The second vulnerability is that the Treasury market is symbiotically connected with another crucial market: the one for “repo” lending, whereby banks and other financial firms borrow from one another by temporarily exchanging Treasuries for cash. Because primary dealers typically use repo transactions to fund their purchases of Treasuries, the two markets are closely linked. The repo interest rate is important to the economy (more so than the “federal funds” rate that the Fed officially targets) and anchors borrowing rates for businesses and households. But when Treasury issuance or the Fed’s operations suck cash out of the banking system, the repo rate can spike unexpectedly, catching policymakers off-guard. This happened in late 2019.
It would be wise to mend the pipes before the next torrent of issuance gushes down them. Some quick fixes are obvious. A temporary exemption of cash and Treasuries from banks’ leverage ratios should be made permanent. Banks should not have to hold capital against assets which are all but risk-free. And the number of primary dealers could also be expanded, so that it matters less if any one of them gets into trouble.
But it would be better still to implement a deeper overhaul. The primary-dealer system is needlessly complex and would never be designed from scratch today. It should be phased out in favour of a central clearing house for Treasury trades which would let smaller firms deal with each other without an intermediary clogging up the market. More debt issuance could take place without middlemen, too.
The Fed must also get a better grip on rates in the repo market, which influences the entire economy. Currently it puts a floor under repo rates but, in normal times, does not cap them. The answer is a “standing repo facility”, through which it would lend at its target interest rate to any counterparty that can provide short-term Treasuries as collateral. These Fed loans would pose little risk to the taxpayer. And with a firmer grip on rates the Fed would have less need to buy government bonds in a panic, a tactic which over time is destined to cause a political stink because it looks as if the government is being financed by the printing presses.
Dodgy financial plumbing is tricky to fix but it has the capacity to cause an almighty mess. It determines how well policy is being transmitted to the economy as a whole. As the pandemic leads to an epic amount of government borrowing and blurs the boundary between fiscal policy and the Fed, it is time for reforms to make the pipes safer.