US Treasury Market Faces Strain Amid Geopolitical Turmoil, Lowering Liquidity

US Treasury Market Under Pressure: Geopolitical Ripples Impact Global Finance

The colossal $30 trillion US Treasury market, a bedrock of global finance, is showing increasing signs of stress. Geopolitical developments, particularly in the Middle East, are triggering notable volatility in the prices of these crucial instruments. While transactions are still executing, Wall Street banks and investors report a significant decline in the ease of trading within this, the world's largest and most critical financial market, over the past few weeks.

Investor Caution and Re-evaluation of Inflation Outlook

The mounting pressure on the market suggests that some investors are pulling back from US Treasury trades. This reaction follows a period of pronounced price swings, marking the most severe bout of volatility since President Trump's announcement of his "Day of Reckoning" tariffs rattled the market in April of last year. For the past four weeks, US Treasury yields have experienced substantial swings on numerous trading days. This volatility stems from investors recalibrating the extent to which surging oil prices will translate into inflation and consequently influence the Federal Reserve's interest rate outlook.

Yield Spikes and Underwhelming Auctions

On Thursday, US Treasuries faced selling pressure, pushing the yield on the two-year Treasury note, highly sensitive to monetary policy, up by 0.12 percentage points to 4%. This month alone, the two-year yield has surged by 0.62 percentage points, marking its worst performance since September 2022. The situation was further underscored by an underwhelming auction of similar-maturity debt held earlier in the week.

Deteriorating Liquidity and Market Depth

Meghan Swiber at Bank of America observed, "Investors are still unsure if we're past the peak of the conflict, and that indecision is leading many to take a wait-and-see approach." Matthew Scott of AllianceBernstein added that over the past month, "liquidity in rates and macro products (i.e., the ease with which traders can buy and sell) has visibly deteriorated." JPMorgan echoed this sentiment this week, noting that the size of trades required to move prices – so-called "market depth" – has diminished nearly as much as it did in the aftermath of the "Day of Reckoning" announcement.

Treasuries' Crucial Role as a Benchmark

Investors and policymakers alike are closely monitoring the functioning of the US Treasury market, as it serves as a vital benchmark for global borrowing costs. Despite the market's deteriorating condition, investors and other market participants maintain that executing large transactions remains feasible.

Natural Market Reaction to External Shocks

James Carter of investment management firm W1M described the decline in market depth as a "natural reaction from market participants pulling back in the face of external shocks." He added, "Historically, these situations tend to be short-lived." Scott of AllianceBernstein pointed out that market depth in the spot market has fallen by approximately 40% to 50% compared to pre-conflict levels, as volatility forces traders to the sidelines. An executive at a large asset manager revealed that market depth in short-dated Treasury futures, widely used for betting on or hedging against bond moves, plunged by as much as 80% this week relative to the year's average.

Equity Market Liquidity Also Thins

Scott Rubner at Citadel Securities noted in a report this week that liquidity in the US equity market has also become "extremely thin." He elaborated that the decline in liquidity, particularly at the top of the order book (representing the best available bid and offer prices), "impedes the ability to quickly transfer risk without creating a shock."

Trading Disruption and Reliance on Manual Processes

Volatility across various markets has surged since the conflict began, but Treasury trading became particularly agonizing on Monday. Early that morning, Trump posted on "Truth Social" about "productive" talks with Iran, only for Tehran to subsequently deny any discussions had occurred. This communication mismatch triggered significant Treasury market volatility.

The US Treasury market's choppiness became so severe that some major Wall Street banks switched off their automated quoting screens, forcing buyers to revert to slower, traditional, manually matched trading methods. Michael Lorizio at Manulife Asset Management observed that investors at times "struggled to put prices on certain Treasuries." He stated, "After the initial direct shock from Trump's post, you saw electronic trading seize up Monday morning. You saw dealers turn off their auto-quote functionality for Treasuries."

Sensitivity to Inflation and Monetary Policy

Inflation-protected securities (TIPS) and short-dated Treasuries were particularly impacted due to their heightened sensitivity to inflation and monetary policy expectations. Currently, futures traders see a greater probability of the Federal Reserve raising interest rates this year than cutting them, a stark contrast to the two to three rate cuts the market had priced in prior to the conflict's outbreak.

Poor Auction Results

Auctions for new tranches of short-dated US government debt this week also proved lackluster. In Tuesday's auction of $69 billion in two-year notes, primary dealers – large banks obligated to buy unsold debt – took down the largest proportion of the offering since 2022. A similar pattern emerged in Wednesday's $70 billion auction of five-year notes, where dealers bought the highest share since early 2024. Thursday's auction of seven-year notes showed a slight improvement but remained weak by historical standards.