It’s hard to overstate the importance of the market for US Treasury securities. It provides a benchmark for prices of stocks and bonds around the world and determines the cost of financing the US budget deficit. To those ends, it must be deep and liquid—able to handle large trading volumes without undue volatility.
But it remains vulnerable to turmoil. US deficit spending has vastly increased the volume of Treasury securities outstanding, dwarfing the balance sheets of the financial institutions at the centre of the market. Meanwhile, authorities lack the proper tools to prevent dysfunction.
Usually, algorithmic firms handle most Treasury trades in a microseconds, transferring securities at prices close to previous transactions. But they lack the capital to take and hold big positions, so they often withdraw when buying or selling becomes one-sided.
This puts the onus on the US and foreign banks known as primary dealers, which also don’t have the capacity to provide enough “liquidity in the large” as they’ve already committed their balance sheets elsewhere. As a result, shocks can trigger dislocations, such as the ‘flash crash’ of 2014 or ‘dash for cash’ of 2020.
Mostly, authorities are able to respond only after damage is done, as the Fed did in 2020 by buying large quantities of Treasuries. The Fed’s standing repo facility, which support liquidity ex ante by lending cash against Treasuries, has some crucial limitations.
It’s available only to primary dealers and large banks, it doesn’t allow them to expand their balance sheets any more than they otherwise could, and some firms are reluctant to tap it for fear that usage would signal weakness.
The Treasury secretary has a few options to address the problem. For one, he can work with the Fed and other regulators to adjust the supplemental leverage ratio, which limits the assets banks can hold for a given amount of equity capital.
If reserves at the Fed and available-for-sale Treasury securities were excluded from the asset calculation, primary dealers could increase their Treasury holdings at times of stress without breaching the ratio.
Another approach would be to broaden the standing repo facility, providing liquidity to any holder of Treasuries that wants it. Primary dealers would act as conduits, but the transactions would not show up on their balance sheets.
Expanding central clearing of Treasury trades could further ease the pressure on dealer balance sheets by facilitating netting of gross positions and allowing more counterparties to trade directly with one another, bypassing the dealers entirely.
Bessent must also address the trend that has been putting pressure on the Treasury market: the US government’s rapidly growing debts. Although he can’t single-handedly put US fiscal policy on a sustainable course, he has a big role to play.
First, he should stress that fiscal imprudence will drive up debt service costs, and advocate measures to increase revenue and limit spending (not just by assuming faster growth or that tax cuts pay for themselves).
Second, he should seek ways to broaden the tax base and ensure everyone pays what they owe.
Third, he should be realistic about the extent to which higher import tariffs can raise revenue—and about their negative impact on growth, inflation and productivity.
Finally, he should support the Fed’s independence on monetary policy. If markets begin to worry that the executive branch will push the Fed to absorb excessive debt issuance (known as monetizing the debt), they’ll demand higher Treasury yields to compensate for the risk of inflation—undermining the US fiscal position by increasing its borrowing costs.
Bessent could stop advocating a shadow Fed chair to undercut Jerome Powell’s authority before his term ends in 2026.
A shadow chair would likely be ineffective in influencing expectations about monetary policy, because the economy is operating near the Fed’s employment and inflation objectives. This makes policy dependent on incoming data rather than on other, more forward-looking considerations.
I do hope Bessent will be successful. Markets’ exuberant response to his nomination certainly suggests this is what investors expect.
Yet, their optimism contrasts sharply with the difficulties he’ll encounter in managing the Treasury market, the country’s fiscal trajectory and the broader economy. ©Bloomberg
The author is the chair of the Bretton Woods Committee and served as president of the Federal Reserve Bank of New York from 2009 to 2018.
