By Jason Dibble, Co-Founder, Editor in Chief, Curatia
TECH TUESDAY is a weekly content series covering all aspects of capital markets technology. TECH TUESDAY is produced in collaboration with Nasdaq.
With a deluge of new issuance, the Fed’s balance-sheet runoff, and proposed regulatory reforms all poised to keep squeezing Treasury market liquidity, traders are desperate for solutions that could forestall a seize-up in periods of market stress. In that quest, Nasdaq-listed single-bond Treasury ETFs show particular promise for their ability to stimulate liquidity.
Their successful launch extends the momentum of single-stock ETFs and taps into rising bond-ETF popularity that emerged as traders hunted liquidity in March 2020. It could also help the Fed navigate a tricky soft landing for the US economy by eliminating the need for a premature end to the central bank’s balance-sheet runoff.
Bond traders saw US Treasury liquidity sink to its lowest levels since March 2020 in June, exposing a bugaboo that experts worry could fester for years.
A broad-based market rally in the weeks following the episode brought Treasury markets some relief. But a hot jobs market continues to lift wages, forcing the Fed to stick to its schedule of aggressive rate hikes to corral inflation. An unexpectedly bullish US jobs report in early August sent Treasury yields higher — and prices lower — sidelining skittish traders.
The trend persisted through most of August, reflecting growing investor conviction that inflation could take years to tame. Fed chair Jerome Powell’s strong backing of the central bank’s aggressive approach to rate hikes at last week’s Jackson Hole conference only reinforced that sentiment, sending Treasuries sharply lower and further stoking liquidity concerns.
The upshot of that shift is that investors are seeing a recession as less likely — a development reflected in a flattening, if still inverted, yield curve.
Even if a cooling economy and ebbing inflation allow the Fed to relent in its schedule of rate increases, a slew of structural headwinds in Treasury markets still threaten a prolonged liquidity drought.
The first is the $3 trillion of new Treasury supply hitting markets over the two-year span that began in March. The coming deluge triggered a warning from Bank of America strategist Mark Cabana that “fragile UST liquidity may be exacerbated by the supply shift in coming months.”
Strained Treasury markets have also prompted Federal Reserve staff themselves to caution that the central bank could face complications in its quest to shrink its balance sheet. Treasury market volatility could amplify the impact of quantitative tightening on interest rates nearly threefold from 0.29% to 0.74%, two July analyses noted, risking tightening financial conditions too sharply.
In addition, the Treasury holdings of some key market participants including pension funds and mutual funds are already near record levels, implying a “limited capacity to absorb” the Treasury Department’s $3T in new issuance, the analyses said.
Complications with QT could come sooner rather than later. Barclays predicted the Fed would need to slow its balance-sheet runoff of Treasury and mortgage bonds in Q1 of 2023 or risk triggering a jump in short-term interest rates that could exacerbate recession risks.
A proposed regulatory overhaul aimed at streamlining Treasury markets’ functioning, meanwhile, could ironically stymie liquidity instead.
Higher costs associated with central clearing and increased reporting requirements for high-speed trading firms registering as dealers could drive those firms out of Treasury markets.
Controversy over the proposed reforms has flared in recent weeks. SIFMA, an industry trade group representing banks, buy-side firms, and proprietary traders, is poised to attack the plans. The proposals have even “ruffled feathers” at the Treasury Department itself, according to Risk.net.
Amid those myriad pressures, traders are desperate for solutions that could forestall a Treasury market seize-up in periods of stress.
The world’s first single-bond Treasury exchange-traded funds, launched by multi-boutique ETF issuer F/m Investments on the Nasdaq exchange in early August, could prove to be a key piece in Treasury markets’ liquidity puzzle. The launch included three ETFs holding US 10-year (UTEN), two-year (UTWO), or three-month (TBIL) Treasury bonds and bills.
The securities offer investors an array of benefits that could promote liquidity. They grant retail investors, who’ve shown a surprising appetite for complex instruments like options during the retail-trading boom, access to advanced yet low-risk Treasury markets — an area largely foreclosed to them via existing retail-brokerage offerings.
Single-bond Treasury ETFs also sell for half the price of Treasuries themselves, allowing even first-time investors to embrace portfolio diversification with Treasury ETF purchases. Over time, that easy entry figures to introduce many more traders to bond markets’ complex mechanics early in their investing careers, broadening retail participation in bond markets.
Sophisticated traders will likewise find a wealth of advantages in F/m Investments’ new offerings. They give traders “targeted exposure to different parts of the yield curve,” according to Morningstar senior fund analyst for passive strategies Kenneth Lamont — a key tool for traders amid heightened uncertainty around Fed rate policy and US recession odds.
In addition, single-bond Treasury ETFs allow traders to short Treasuries as well as go long, giving traders a potentially lucrative alternative to sitting on the sidelines as prices fall. That added flexibility could help keep market participation more constant during periods of market stress, addressing a key market weakness.
“Short interest in the newly launched funds illustrates how investors can benefit from increasing yields, invest in widening or tightening Treasury spreads, or invest in Treasuries when corporate spreads are widening,” F/m Investments CIO Alexander Morris said.
F/m Investments’ new offerings also accord traders key logistical benefits. They offer tax efficiencies over holding Treasuries themselves. And they allow institutional investors and investment advisors to avoid complexities around custody and treasury.
Collectively, those benefits could help coax timid traders back into Treasury markets while attracting a new crop of novice investors into the fold.
Such momentum could also become self-reinforcing. Investors have consistently pivoted to bond ETFs during periods of market stress for their superior ability to provide price discovery in real time. That dynamic helped push bond ETF trading to record levels during June’s Treasury market ructions.
By promoting Treasury market liquidity, single-bond Treasury ETFs could even play a role in helping the Fed navigate a tricky soft landing for the US economy.
The pace of its balance-sheet runoff is slated to double to $95 billion a month in September, further pressuring Treasury market liquidity. Market developments that counteract those pressures curb the risk that the Fed will have to end quantitative tightening prematurely, giving it more options for managing inflation while keeping the economy humming.
That wealth of promising possibilities has driven strong early interest in single-bond Treasury ETFs among Wall Street traders, extending the momentum of single-stock ETFs and taps into rising bond-ETF popularity that emerged as traders hunted liquidity in March 2020.
Coverage of the launch was one of Curatia’s most-read stories in a pre-Labor Day news cycle surprisingly teeming with popular topics.
Even more promising for single-bond Treasury ETFs — and, by extension, liquidity-starved Treasury investors — is the likelihood that liquidity benefits associated with the offerings will continue to ramp up over time.
The ETFs’ uptake only figures to grow as investors become increasingly comfortable with how to deploy them to maximum effect.
That uptake could get a boost once the Fed ends its current rate-hike cycle and begins to cut rates again. That’s because F/m Investments’ ETFs roll into new on-the-run bonds as soon as existing holdings go off the run — a mechanic that could generate additional profits for investors in a falling-rate environment.
Some experts think that could occur as early as next year. In August, JPMorgan strategists said in a note that they expect the Fed to deliver its last big rate hike in September.
While Mr. Powell signaled unambiguously last week that he expects to keep raising rates to combat inflation, that action could ultimately force an earlier unwind to higher rates if it pushes the US economy into a recession. Rising geopolitical tensions could likewise push the Fed’s rate-cut timeline forward by precipitating a global recession.
Single-bond Treasury ETFs could also benefit from a broad investor push to harvest tax losses in mutual funds and Treasuries themselves while moving to more tax-efficient ETFs. The trend has buoyed ETFs even as mutual funds have struggled this year.
Additional products could further boost liquidity by expanding investors’ Treasury trading options. F/m Investments has seven more Treasury ETFs in the pipeline. They could help traders equitize the yield curve with greater precision as Treasuries of varying durations move in different directions, causing the curve to invert or right itself.
Additional launches beyond what’s already in the pipeline would further enhance that capability, as would the maturing of the options market around single-bond Treasury ETFs.
“Investor feedback is accelerating our launches across the yield curve and helping us innovate new rates products,” Mr. Morris said.
Their potentially wide-ranging appeal to diverse investor audiences herald the future development of an investing ecosystem around single-bond Treasury ETFs.
Amid a maelstrom of uncertainties surrounding Treasury liquidity, that could be just what the doctor ordered.
This column was originally written by Curatia co-founder Jason Dibble and published by Curatia LLC, a subscription-based news and analytics platform for the traders and technologists. To sign up for a free trial of Curatia’s service, visit https://account.curatia.com/register.