Policymakers should broaden central clearing and monitor market-making, including by nonbank financial institutions, while dealers must continue to build resilience
By Tobias Adrian, Kleopatra Nikolaou, Jason Wu
The smooth functioning of government bond markets is important for the safety and soundness of broader capital markets, especially amid heightened financial market volatility. Bond markets recently adjusted sharply to an abrupt re-assessment of the global macroeconomic environment and elevated trade policy uncertainty.
Government bond market functioning demonstrated resilience despite very high volatility, and its continued stability remains essential for the financial system, as we show in the latest Global Financial Stability Report, which also assesses cross-country vulnerabilities in other financial sectors and markets.
Government bonds are the bedrock of capital markets, serving as benchmarks whose yields influence other financial instruments like corporate bonds, mortgages, and derivatives. Many financial transactions use government securities as collateral for hedging against risk, and to guide pricing.
Bond yields and their movements reflect information about economic prospects, risks, and market functioning. For instance, when yields rise for fundamental reasons, this typically reflects an improved economic outlook or higher inflation expectations. Such pricing is determined by the balance of supply and demand in an environment where many central banks are normalizing their balance sheets and governments continue to finance high volumes of debt. In fact, the share of government debt held by private investors is likely to rise in major economies.
Yields can also rise when investors demand additional compensation for uncertain interest rates over the duration of the bond, known as the term premium. Uncertainty could reflect fiscal, economic, or most relevant currently, trade policy uncertainty. If higher risk premia are further aggravated by issues in the functioning of government bond markets, yields rise excessively relative to fundamentals, potentially undermining the efficient allocation of capital.
Global policymakers have made significant strides in shoring up the $80 trillion government bond market in the face of mounting challenges, but more work is needed to enhance resilience. Ensuring that intermediaries and market structures are sound is essential. Effective functioning requires liquid markets that enable buyers and sellers to easily match bids and offers, allow yields to efficiently reflect economic changes, and help keep term premia low. Some episodes in recent years suggest that core bond market liquidity can evaporate quickly in times of stress, and that even day-to-day liquidity may deteriorate.
Liquidity is a multi-faceted concept, measured by transaction-level metrics like the spread between bid and ask prices, trading volumes, and market depth—and model-based methods. Different metrics can at times convey different signals. For example, while bid-ask spreads suggest mild pressure on liquidity in the past few years, yield curve fitting errors have increased for some of the world’s largest bond markets, suggesting reduced liquidity.
These disparities between yields on bonds with similar maturities underscore the need to better understand the mechanisms that affect liquidity. This begins with gauging the state of primary dealers, which bid in auctions on behalf of clients and support liquidity in secondary markets and are the main intermediaries of major government bond markets. Most are subsidiaries of large banks. Many have sizable balance sheets that can warehouse bond inventory and provide clients with financing.
Dealer intermediation dynamics can significantly affect liquidity. In volatile markets, dealers face a rise in value-at-risk and other risk management metrics, challenging their ability to act as intermediaries. Bank dealers may step back during heightened volatility, worsening liquidity. Overall, increased dealer perceptions of risk can reduce market-making activity and amplify market illiquidity, as shown in our recent paper coauthored with the Federal Reserve Bank of New York.
Major bank-dealers of core sovereign bond markets have expanded their government bond holdings, but not in proportion to the growth in the size of outstanding bonds. For example, in the United Kingdom, gilts grew twice as fast as UK bank-dealer balance sheets, as we showed in the October 2023 Global Financial Stability Report. The stock of US Treasury securities grew nearly fourfold in the 15 years through 2023, while US bank-dealer balance sheets expanded by just 1.5 times.
As a result, US Treasury securities account for almost 70 percent of primary dealers’ securities inventories, the highest share in over a decade, while about three-quarters of their securities financing is also collateralized by Treasuries. The challenge is that dealers’ internal limits on concentrated holdings could curtail intermediation activities, especially in times of stress.
The resilience of market functioning also depends on nonbank financial institutions. Some NBFIs—mutual funds, exchange-traded funds, insurance companies, and pension funds—are key buyers. Others have become important market-makers in specific market segments, particularly principal trading firms and some hedge funds. The shift toward electronic trading has helped principal trading firms with technological expertise to gain market share.
NBFI market-makers can help reduce investors’ reliance on bank-dealers, increase the number of intermediaries, and improve liquidity. However, because they have a generally weaker mandate to support government bond markets compared to bank-dealers, they may also quickly curb activities during times of market stress. That was the case during the 2014 Treasury market flash rally in and the 2020 global dash-for-cash at the onset of the pandemic, while their role in the recent episode of bond volatility is still being analyzed. Furthermore, the increasing presence of NBFIs makes market resilience more uncertain and opaque because they tend to be less regulated and subject to fewer data reporting requirements.
Policy progress
The resilience and liquidity of the bond market during shocks underpin its status as a safe asset, which consequently supports the broader stability of global financial markets. This, in turn, is an important determinant of the funding costs of governments. Therefore, policies to safeguard market functioning are needed to strengthen this resilience.
To mitigate breakdowns, central banks have introduced new tools in recent years to stabilize bond markets. These include asset purchases and lending facilities—primarily through repurchase agreements, or repos—which provide loans to financial institutions collateralized by government bonds.
While these tools help support bond market functioning, they’re no substitute for structural resilience. Central clearing mitigates counterparty and default risks and improves transparency. It also allows intermediaries to offset long and short positions against the central counterparty, boosting balance sheet efficiency and capacity.
Countries have embraced central clearing to varying degrees. In Japan, significant shares of both the cash and repo transactions are centrally cleared, while the United States only recently introduced a mandate. In Germany and the United Kingdom, some repo trades are centrally cleared but cash transactions aren’t. While central clearing by itself does not guarantee market resilience, international consensus on its benefits is steadily growing.
Moreover, timely and comprehensive market data is crucial for evaluating market functioning. The recent volatility has shown that data gaps and reporting lags obscure real-time drivers of market functioning, such as selling pressures in the sovereign bond market. Progress has not been uniform across countries, while important data gaps remain for key market participants such as dealers and hedge funds. Further steps are needed to ensure timely and consistent data on government bond liquidity and functioning.
More work is required in other areas. Policymakers must further assess changes to market-making, notably the growing role of NBFIs. To do this, they need better information on NBFIs’ financial soundness, operational resilience to threats like cyberattacks, and how they are likely to behave when bond markets are under duress.
Finally, since bank-dealers are likely to remain essential to government bond markets, they must continue to build capital and liquidity during stable times to serve markets under stress. Completing internationally agreed regulatory reforms for banks will be key to achieving this goal.
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