View: Creaking US bond market signals danger still lurks

Global markets are breathing a huge sigh of relief following U.S. president Donald Trump's surprise announcement of a 90-day hiatus in much of his tariff agenda, but it would be premature to think the dangers posed by the U.S. bond market dysfunction this week have suddenly disappeared.

When financial crises migrate to Treasuries, regulators start to get very nervous, as stress here can lead to large, rapid shifts in prices that suddenly clog up market 'plumbing' and inhibit its functioning, requiring the Federal Reserve to step in.

And cracks started to appear this week in the $29 trillion Treasury market, the bedrock of the global financial system and the benchmark for trillions of dollars of loans globally, as investors dumped huge amounts of long-dated bonds.

The moves in Treasuries and swap spreads were extraordinary, in some cases historic. The 30-year swap spread briefly widened through -100 basis points on Tuesday, its most negative since the pandemic. The 10-year yield at one point was up more than 40 bps and on course for its biggest weekly rise since 2001. And the 30-year yield gapped up 60 bps, on track for its biggest weekly rise since 1981.

These moves were not reflective of a liquid, well-functioning market, especially as they came in a deep 'risk off' environment, which should, in theory, have been spurring huge safe-haven inflows.

Indeed, the speed and scale of liquidation in the scramble to raise cash, limit losses and meet margin calls had echoes of the early days of the pandemic crisis five years ago. Tensions had cooled a bit even before Trump's announcement on Wednesday, but yields remain elevated, and the trade war is far from over - just ask China - so these bond tremors could easily erupt again.

MARKET FUNCTIONING

Federal Reserve officials will thus continue to watch keenly for any warning signs of danger ahead, including evaporating liquidity, plummeting demand, widening bid-offer spreads and 'gapping' yields in certain parts of the curve.

The Fed will be on the lookout for a 'buyers' strike', whether that's domestic or foreign investors, something that may have been brewing this week before Trump's tariff surprise. Bank of America's Meghan Swiber warned earlier on Wednesday that further deleveraging and liquidation risked a downward spiral that could only be halted by official intervention.

What would the Fed's options be in this scenario? Interest rate cuts would be highly unlikely, as they would not be especially helpful in resolving a market dislocation issue.

The central bank has amassed an array of liquidity backstops and lending facilities since 2008, such as the overnight reverse repo program, standing repo facility, dollar swap lines with foreign central banks, and the discount window. These tools could all be sharpened, deployed or extended as policymakers see fit.

The Fed could also announce a temporary or permanent exemption for Treasuries in banks' Supplementary Leverage Ratio calculations, which would ease bond market strains and encourage banks to keep the lending taps open. It could also end its balance sheet runoff, or quantitative tightening program, earlier than planned.

And in extremis, if the market really froze like it did in 2020 and 2008, the Fed could go full circle and start buying bonds again.

That's the ultimate bazooka, which the Fed will be loath to dust down and fire. It would prefer not to be called upon at all, and maybe Trump's tariff pause means it won't have to. But more volatile weeks like this one in Treasuries, and it may have no choice.

(The opinions expressed here are those of the author, a columnist for Reuters.)