Market Stress Snarls Trading in U.S. Treasurys

Traders said the turmoil, driven in part by fear that an economic reversal might be ahead, was rippling into stocks and fueling the 682-point decline Wednesday in the Dow industrials. The spreads quoted in markets for Treasurys and derivatives tied to other government bonds, reflecting the gap between quoted prices to buy and sell, were far wider on Wednesday than they were last week, the traders said.

The ICE BofA Move Index, a measure of volatility in the bond market, rose to the highest levels in at least three years, surpassing levels recorded during the March 2020 market crash.

Aside from the trading dysfunction, investors generally agreed that fear of economic distress was driving down interest-rate expectations and pushing investors to dump riskier assets in favor of safer ones, following the U.S. bank rout and a sharp decline Wednesday in shares of Swiss lender

Credit Suisse Group AG

CS -21.31%

.

“People don’t want to be caught with the next Silicon Valley Bank or the next Credit Suisse,” said John Sheehan, a fixed-income portfolio manager at Osterweis Capital Management. “They’re buying what they think will outperform.”

The ease of buying and selling Treasurys makes them the bedrock of Wall Street trading, used to park money or as collateral on loans. When the market breaks down, the resulting turmoil can rapidly spread to other assets, hitting everything from stocks to currencies. One episode occurred in October 2001, when problems trading Treasurys spread to the market for short-term lending upon which banks and investment firms depend.

Concerns about Treasury liquidity have been perennial since the financial crisis, reflecting changes in market rules and a reduced role in many areas for large banks. But many traders and investors said the action Wednesday was as strained as they have seen in recent years. They warned that continuing Treasury market dysfunction could add a new element of stress to markets already reeling under threat from inflation, U.S. bank failures and fears that distress here might be spreading to Europe.

Treasurys set borrowing costs across the economy, used as collateral for loans, and serve as a benchmark against which other assets are measured. Any hint of stress in this market, widely considered to be the most liquid in the world, therefore always rings alarm bells.

One driver of the unruly trading: the significant change over the past week in the outlooks for global growth and inflation, reflecting concerns that the bank mess might signal a sharp slowdown ahead.

Options prices tied to interest-rate derivatives were swinging wildly Wednesday, said Arthur Bass, managing director at Wedbush Securities. Many traders rushed to hedge volatility in the market for two-year Treasurys after large moves in recent days.

“Markets operate on greed and fear,” Mr. Bass said. “Fear is overriding greed right now.”

Some traders said that despite continuing worries about the capacity to buy and sell quickly without moving prices, Treasurys and bunds typically remain easier to trade than most other asset classes, such as corporate bonds and many commodities.

One factor driving the current disruption has been the massive flows into and out of Treasurys and bunds. Demand for these so-called safe-haven assets typically rises in times of stress in markets, but prices for safe bonds have been under pressure for much of the past year as the Federal Reserve and other global central banks sharply raised interest rates in a bid to fend off inflation.

After a year of heavy selling, bonds rallied powerfully over the past week as the U.S. government took over two troubled banks, marking the second- and third-largest bank failures on record, and Credit Suisse came under attack in the market on Wednesday. The repeated reversals of flows have added to existing stress, traders said. 

Credit Suisse’s largest shareholder, Saudi National Bank, said Wednesday that it wouldn’t invest more in the Swiss lender, hitting investor sentiment. The bank’s riskiest bonds traded at around 45 cents on the dollar and liquidity for European bank bonds broadly declined, analysts said.

“This is an animal spirits reaction,” said Jerome Legras, managing partner at Axiom Alternative Investments, a fund that specializes in bank debt. “It doesn’t really make sense from a fundamental point of view.”

This rapidly spread to the government bond market, extending the recent plunge in yields. On Wednesday, the 10-year U.S. Treasury yield fell to 3.41% and the German bund of the same maturity dropped to 2.13%. Many global stock indexes were down 1% or more.

Some traders said that the market moves were some of the wildest they had seen in their careers, with yields dropping sharply after the U.S. government’s Sunday night bank rescue plan was announced, only to stage a reversal the next day. Government bond prices have logged swings not recorded in decades, when Paul Volcker was chairman of the Federal Reserve and looked to tame inflation.

“You can’t have a conversation with Treasury traders without them going on a rant about Treasury liquidity,” said Hani Redha, a multiasset portfolio manager at PineBridge Investments. “That just means that moves get amplified. You’re going to get overshoots in both directions.”

On Monday, the two-year Treasury yield dropped to 4.028%, the biggest one-day fall since 1987 around the Black Monday market crash. Meanwhile, the yield-curve inversion—the bond market’s classic recession indicator—unwound at a record clip this week.

Zhiwei Ren, a portfolio manager at Penn Mutual Asset Management, said he couldn’t recall a time when the bond market was this volatile.

He said he was trading swaps, a type of derivative contract, in recent days and the difference between buy and sell prices tied to the trades was roughly four or five times what they typically are. Swaps are financial contracts in which counterparties agree to exchange payments based on, say, changes in the prices of bonds or stocks. They are often used by professional traders to hedge positions.

“It takes a longer time to transact,” Mr. Ren said.

Liquidity is far from the only factor in the large swings this month in these markets, many investors and analysts say. Quantitative investment strategies also helped fuel the dramatic price swings.

After enjoying a record-breaking year betting bond prices would fall, algorithmic money managers that ride market trends are racing to close out their short positions, or purchasing securities previously borrowed and sold in a bid to benefit from falling prices.

Computer-driven funds such as commodity trading advisers, or CTAs, had taken large bearish positions in the Treasury market in recent weeks, according to

Société Générale SA

. That exacerbated the recent swings as traders rushed to cover their positions when bonds rallied and yields dropped, catching some traders wrong-footed by the moves.

“These types of platforms were all mostly short bonds,” said Matt Smith, investment director at London-based asset manager Ruffer LLP. “Many have probably hit their stop-losses and have had to be buyers,” he added, referring to bond buying triggered by predetermined levels of trading losses.

Trend-following funds scooped up roughly $128 billion of eurodollar futures, contracts tied to the expected level of benchmark interest rates, in the past week to close out their so-called short trades, according to Nomura estimates. They bought another $49 billion of sovereign bonds from G-10 countries. Totals reflect the underlying assets’ value in the futures contracts traded.

The swift reversal in expectations for Fed rate increases and bond yields led quant funds to their worst two-day stretch on record since at least 2000, falling 7.7%, according to Nomura.

Quants had built up mountainous positions since the Fed began raising rates roughly a year ago. Such funds also tend to prefer less volatile markets, beefing up their exposures in calmer markets and paring them back when jitters rise. While the algorithmic bond-buying spree has helped fuel the latest surge in volatility, it also perpetuates their short-covering.

Even so, the liquidity problem has been gnawing at traders, regulators and investors for years. Investors say chronic concerns about the ease of trading intensified when post-financial-crisis regulation prevented banks from trading for themselves and forced them to hold larger amounts of capital, effectively shrinking their inventory of riskier assets. This, in turn, reduced banks’ ability to serve as intermediaries between buyers and sellers.

More recently, the boom-bust dynamics of markets have tested trading capacity repeatedly. The Covid crash of three years ago quickly gave way to the stimulus-fueled market recovery of later 2020 and 2021, and then came the inflation scare of 2022 in which the Fed embarked on the steepest rate-increase cycle in decades. Each of those developments tested bond markets as massive money flows changed direction, wrong-footing many traders and forcing significant changes in positions.

But the recent closings of two major U.S. banks has intensified already challenging trends, traders said. Liquidity in the market for 10-year Treasury futures has been less than half the levels recorded before the Silicon Valley Bank collapse, according to data from Quantitative Brokers. The firm looked at the number of 10-year Treasury futures contracts available to buy and sell at the best market prices available, a proxy for the ability to move in and out of positions quickly.

The federal government’s move to swoop in and rescue bank depositors snuffed out one form of uncertainty but perpetuated another, said Mr. Smith of Ruffer said.

By acting so swiftly to reassure bank depositors nationwide this week, government and Fed officials have scrambled investors’ assumptions about how committed they are to fighting inflation at the expense of economic growth—a shift that portends further chaotic trading across asset markets ahead, he said.

“There’s an aphorism that says you can never suppress volatility, you can only move it somewhere else,” Mr. Smith said.

—Sam Goldfarb, Joe Wallace and Matt Grossman contributed to this article.

Write to Gunjan Banerji at [email protected], Anna Hirtenstein at [email protected] and Eric Wallerstein at [email protected]

Traders said the turmoil, driven in part by fear that an economic reversal might be ahead, was rippling into stocks and fueling the 682-point decline Wednesday in the Dow industrials. The spreads quoted in markets for Treasurys and derivatives tied to other government bonds, reflecting the gap between quoted prices to buy and sell, were far wider on Wednesday than they were last week, the traders said.

The ICE BofA Move Index, a measure of volatility in the bond market, rose to the highest levels in at least three years, surpassing levels recorded during the March 2020 market crash.

Aside from the trading dysfunction, investors generally agreed that fear of economic distress was driving down interest-rate expectations and pushing investors to dump riskier assets in favor of safer ones, following the U.S. bank rout and a sharp decline Wednesday in shares of Swiss lender

Credit Suisse Group AG

CS -21.31%

.

“People don’t want to be caught with the next Silicon Valley Bank or the next Credit Suisse,” said John Sheehan, a fixed-income portfolio manager at Osterweis Capital Management. “They’re buying what they think will outperform.”

The ease of buying and selling Treasurys makes them the bedrock of Wall Street trading, used to park money or as collateral on loans. When the market breaks down, the resulting turmoil can rapidly spread to other assets, hitting everything from stocks to currencies. One episode occurred in October 2001, when problems trading Treasurys spread to the market for short-term lending upon which banks and investment firms depend.

Concerns about Treasury liquidity have been perennial since the financial crisis, reflecting changes in market rules and a reduced role in many areas for large banks. But many traders and investors said the action Wednesday was as strained as they have seen in recent years. They warned that continuing Treasury market dysfunction could add a new element of stress to markets already reeling under threat from inflation, U.S. bank failures and fears that distress here might be spreading to Europe.

Treasurys set borrowing costs across the economy, used as collateral for loans, and serve as a benchmark against which other assets are measured. Any hint of stress in this market, widely considered to be the most liquid in the world, therefore always rings alarm bells.

One driver of the unruly trading: the significant change over the past week in the outlooks for global growth and inflation, reflecting concerns that the bank mess might signal a sharp slowdown ahead.

Options prices tied to interest-rate derivatives were swinging wildly Wednesday, said Arthur Bass, managing director at Wedbush Securities. Many traders rushed to hedge volatility in the market for two-year Treasurys after large moves in recent days.

“Markets operate on greed and fear,” Mr. Bass said. “Fear is overriding greed right now.”

Some traders said that despite continuing worries about the capacity to buy and sell quickly without moving prices, Treasurys and bunds typically remain easier to trade than most other asset classes, such as corporate bonds and many commodities.

One factor driving the current disruption has been the massive flows into and out of Treasurys and bunds. Demand for these so-called safe-haven assets typically rises in times of stress in markets, but prices for safe bonds have been under pressure for much of the past year as the Federal Reserve and other global central banks sharply raised interest rates in a bid to fend off inflation.

After a year of heavy selling, bonds rallied powerfully over the past week as the U.S. government took over two troubled banks, marking the second- and third-largest bank failures on record, and Credit Suisse came under attack in the market on Wednesday. The repeated reversals of flows have added to existing stress, traders said. 

Credit Suisse’s largest shareholder, Saudi National Bank, said Wednesday that it wouldn’t invest more in the Swiss lender, hitting investor sentiment. The bank’s riskiest bonds traded at around 45 cents on the dollar and liquidity for European bank bonds broadly declined, analysts said.

“This is an animal spirits reaction,” said Jerome Legras, managing partner at Axiom Alternative Investments, a fund that specializes in bank debt. “It doesn’t really make sense from a fundamental point of view.”

This rapidly spread to the government bond market, extending the recent plunge in yields. On Wednesday, the 10-year U.S. Treasury yield fell to 3.41% and the German bund of the same maturity dropped to 2.13%. Many global stock indexes were down 1% or more.

Some traders said that the market moves were some of the wildest they had seen in their careers, with yields dropping sharply after the U.S. government’s Sunday night bank rescue plan was announced, only to stage a reversal the next day. Government bond prices have logged swings not recorded in decades, when Paul Volcker was chairman of the Federal Reserve and looked to tame inflation.

“You can’t have a conversation with Treasury traders without them going on a rant about Treasury liquidity,” said Hani Redha, a multiasset portfolio manager at PineBridge Investments. “That just means that moves get amplified. You’re going to get overshoots in both directions.”

On Monday, the two-year Treasury yield dropped to 4.028%, the biggest one-day fall since 1987 around the Black Monday market crash. Meanwhile, the yield-curve inversion—the bond market’s classic recession indicator—unwound at a record clip this week.

Zhiwei Ren, a portfolio manager at Penn Mutual Asset Management, said he couldn’t recall a time when the bond market was this volatile.

He said he was trading swaps, a type of derivative contract, in recent days and the difference between buy and sell prices tied to the trades was roughly four or five times what they typically are. Swaps are financial contracts in which counterparties agree to exchange payments based on, say, changes in the prices of bonds or stocks. They are often used by professional traders to hedge positions.

“It takes a longer time to transact,” Mr. Ren said.

Liquidity is far from the only factor in the large swings this month in these markets, many investors and analysts say. Quantitative investment strategies also helped fuel the dramatic price swings.

After enjoying a record-breaking year betting bond prices would fall, algorithmic money managers that ride market trends are racing to close out their short positions, or purchasing securities previously borrowed and sold in a bid to benefit from falling prices.

Computer-driven funds such as commodity trading advisers, or CTAs, had taken large bearish positions in the Treasury market in recent weeks, according to

Société Générale SA

. That exacerbated the recent swings as traders rushed to cover their positions when bonds rallied and yields dropped, catching some traders wrong-footed by the moves.

“These types of platforms were all mostly short bonds,” said Matt Smith, investment director at London-based asset manager Ruffer LLP. “Many have probably hit their stop-losses and have had to be buyers,” he added, referring to bond buying triggered by predetermined levels of trading losses.

Trend-following funds scooped up roughly $128 billion of eurodollar futures, contracts tied to the expected level of benchmark interest rates, in the past week to close out their so-called short trades, according to Nomura estimates. They bought another $49 billion of sovereign bonds from G-10 countries. Totals reflect the underlying assets’ value in the futures contracts traded.

The swift reversal in expectations for Fed rate increases and bond yields led quant funds to their worst two-day stretch on record since at least 2000, falling 7.7%, according to Nomura.

Quants had built up mountainous positions since the Fed began raising rates roughly a year ago. Such funds also tend to prefer less volatile markets, beefing up their exposures in calmer markets and paring them back when jitters rise. While the algorithmic bond-buying spree has helped fuel the latest surge in volatility, it also perpetuates their short-covering.

Even so, the liquidity problem has been gnawing at traders, regulators and investors for years. Investors say chronic concerns about the ease of trading intensified when post-financial-crisis regulation prevented banks from trading for themselves and forced them to hold larger amounts of capital, effectively shrinking their inventory of riskier assets. This, in turn, reduced banks’ ability to serve as intermediaries between buyers and sellers.

More recently, the boom-bust dynamics of markets have tested trading capacity repeatedly. The Covid crash of three years ago quickly gave way to the stimulus-fueled market recovery of later 2020 and 2021, and then came the inflation scare of 2022 in which the Fed embarked on the steepest rate-increase cycle in decades. Each of those developments tested bond markets as massive money flows changed direction, wrong-footing many traders and forcing significant changes in positions.

But the recent closings of two major U.S. banks has intensified already challenging trends, traders said. Liquidity in the market for 10-year Treasury futures has been less than half the levels recorded before the Silicon Valley Bank collapse, according to data from Quantitative Brokers. The firm looked at the number of 10-year Treasury futures contracts available to buy and sell at the best market prices available, a proxy for the ability to move in and out of positions quickly.

The federal government’s move to swoop in and rescue bank depositors snuffed out one form of uncertainty but perpetuated another, said Mr. Smith of Ruffer said.

By acting so swiftly to reassure bank depositors nationwide this week, government and Fed officials have scrambled investors’ assumptions about how committed they are to fighting inflation at the expense of economic growth—a shift that portends further chaotic trading across asset markets ahead, he said.

“There’s an aphorism that says you can never suppress volatility, you can only move it somewhere else,” Mr. Smith said.

—Sam Goldfarb, Joe Wallace and Matt Grossman contributed to this article.

Write to Gunjan Banerji at [email protected], Anna Hirtenstein at [email protected] and Eric Wallerstein at [email protected]