'Extraordinary' U.S. government debt may mean prolonged bond-market volatility

By Vivien Lou Chen

$27.5 trillion of Treasury debt could be straining global capital markets in a way that wasn't the case 10 or 20 years ago, strategist says

Roughly $27.5 trillion of debt issued by the U.S. Treasury is in the hands of the public, more than twice as much as 10 years ago and over six times as much as 20 years ago.This fact may be one the biggest reasons why bond-market volatility has picked up, according to strategists and traders. And uncertainty over the fiscal outlook is raising the possibility that the market will continue to remain unsettled.

The focus is shifting to the U.S. government-debt burden as tensions fade in the Middle East and traders await a pair of potentially market-moving data in the form of Thursday's first-quarter GDP reading and Friday's March data on the Federal Reserve's preferred inflation gauge. Investors have been watching Treasury auctions more carefully since last year to determine whether U.S. debt can still be easily absorbed, and recent weakness in the demand for some long-dated maturities has stoked worry. Meanwhile, the ICE BofAML MOVE Index , which tracks bond-market volatility, remains near some of its highest levels of the past month after a stream of stronger-than-expected economic data led to aggressive selloffs in 10- BX:TMUBMUSD10Y and 30-year Treasurys BX:TMUBMUSD30Y earlier in April. The index is also higher than where it was during most of 2020 and through the early part of 2022."Volatility in the Treasury market is usually a function of uncertainty and the trading capacity that comes from liquidity providers, like primary dealers," said David Gagnon, managing director and head of Treasury trading for Academy Securities in San Diego, Calif. "That amount of capital hasn't kept pace with the larger amount of debt outstanding. In other words, the capacity of the system to provide liquidity seems to be lagging the rising demands for market liquidity due to the size of the debt."

The Treasury Department "would probably see that as a challenge to a well-functioning market," Gagnon said via phone on Tuesday. "Ironically, the certainty of higher debt and the uncertainty of the pace of that growth could increase volatility." Bond-market volatility has persisted since the Federal Reserve's last rate hike on July 26, 2023 - with the benchmark 10-year Treasury yield experiencing sharp swings in both directions. Since last July, the yield has traded in a wide range between 3.8% and almost 5%.

According to David Kelly, chief global strategist for J.P. Morgan Asset Management, increased bond-market volatility isn't the result of U.S. economic growth, swings in financial markets generally, or even inflation expectations. Instead, the strategist points to the current size of the $27.5 trillion Treasury market. He said in a note on Monday that "it is quite possible that this extraordinary level of debt is straining global capital markets in a way that just wasn't the case 10 or 20 years ago, leading to more volatility."This impact may be amplified by the Fed's quantitative tightening process, which is transferring more Treasurys into the hands of the private sector and away from the Fed, Kelly said. Still-elevated short-term interest rates from the Fed and the central bank's sensitivity to inflation could also be playing a role. "Under any of these explanations, bond market volatility could be here for some time to come," according to the strategist. "There is no evidence that Washington is going to rein in fiscal deficits or that regulators will act aggressively to deepen liquidity in Treasury markets."

On Tuesday, financial markets held steady. Two- BX:TMUBMUSD02Y through 30-year Treasury yields BX:TMUBMUSD30Y finished slightly lower after S&P Global data showed slower increases in activity across the manufacturing and services sectors. All three major U.S. stock indexes DJIA SPX COMP closed higher in New York trading, with the Dow Jones Industrial Average up for the fourth straight session.

In January, the Treasury reduced its estimate for federal borrowing during the first quarter, to $760 billion. The department also said that it expected to borrow $202 billion in the current quarter, assuming a cash balance of $750 billion at the end of June. Updated figures are scheduled to be released next Monday.

-Vivien Lou Chen

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04-23-24 1601ET

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