[The Editors' Verdict] The Precarious Treasury Market

Published 16 Mar.2021 13:54(KST)

Kim Kyung-soo, Professor Emeritus at Sungkyunkwan University

The price of U.S. Treasury bonds, the world's safe-haven asset, is plummeting at the speed of light, causing turmoil in the financial markets. The yield on the 10-year Treasury bond, a key interest rate used to calculate the returns on various fixed-income securities and the value of stocks, has tripled compared to last summer.

The rise in Treasury yields reflects inflation expectations triggered by the Biden administration's stimulus package, which amounts to 25% of the gross domestic product (GDP). Typically, expected inflation is calculated by subtracting the yield on Treasury Inflation-Protected Securities (TIPS), which serve as a proxy for real interest rates (-0.62% as of the 12th), from the 10-year Treasury yield (1.64% as of the 12th), resulting in 2.26%.

Real interest rates have also risen by 0.46% since the beginning of the year. This is due to the increased aggregate demand pressure that has taken hold amid economic recovery. Expectations that the U.S. Federal Reserve (Fed) will shift to a tightening mode earlier than anticipated due to the faster-than-expected recovery are also factored in. The Fed has made it clear that it has no intention to intervene unless the financial markets become disorderly. Although the dollar's value has risen and stock prices have fluctuated, there are no abnormal signs in the financial markets. The U.S. Volatility Index (VIX), known as the fear gauge, remains stable.

However, it is difficult to predict the ripple effects that the supply shock in the global safe-haven asset market will have in the future. Despite the smooth progress of three $120 billion new Treasury auctions last week, the 10-year Treasury yield surged by 10 basis points (1bp = 0.01 percentage points) on Friday. The sell-off in Treasury futures in Asia triggered this. Herd behavior, where everyone follows once someone makes a move, tends to occur when markets are unstable.

Not all Treasury yields have risen. Yields on short-term Treasury bills (T-bills) with maturities of two years or less have actually fallen. The yield on the January maturity has dropped to one-third of the level at the beginning of the year. This is because the U.S. government replaced supply of short-term securities with maturities of two years or less with medium- to long-term securities (T-notes and T-bonds) of three years or more, prompting investors to substitute scarce short-term securities for medium- to long-term ones.

The sharp rise in medium- to long-term Treasury yields also suggests an underlying liquidity issue. This trend may continue as the U.S. government floods the market primarily with medium- to long-term bonds in the future. Experts predict that unless the temporary measure introduced early in the COVID-19 pandemic to exclude Treasuries and cash from banks' capital ratio calculations is extended, liquidity problems will worsen. This is because it will become more difficult for banks to act as market makers in the Treasury market. If U.S. Treasuries face difficulties in fulfilling their role as the global economy's safe-haven asset, it remains to be seen whether the financial markets can provide a highly liquid safe asset to replace them.

Above all, the fundamental reason for the sharp drop in U.S. Treasury prices is insufficient demand relative to the increasing supply. U.S. Treasuries issued before the COVID-19 pandemic have already exceeded 100% of GDP. The share of foreign holders such as emerging market central banks, which once approached 50%, now falls short of 35%, with the Fed filling the gap as a major holder (23%).

One columnist described the U.S. Treasury market as "an elephant growing bigger trying to balance on a shrinking tightrope." It is no coincidence that the price of Bitcoin, created out of distrust toward a government that monopolizes the minting rights, is breaking through ceilings.