1. Recalculating the Risk-Free Rate of Return
- While Treasuries may still be well and truly backed, their markets are becoming more illiquid than ever before in the US$23.7 trillion market.
- With the Fed upping the pace at which it plans to offload Treasuries from its balance sheet to US$60 billion a month, the once deep and liquid Treasury markets are becoming an increasing source of concern and volatility.
Whilst it’s not uncommon to use U.S. Treasuries when calculating the risk-free rate of return to benchmark other riskier investments, one thing that most investors may have not have factored into the mix is the liquidity premium.
U.S. sovereign debt is considered by many investors as the safest investment vehicle, with deep liquid markets and the backing of the government of the United States of America.
But while Treasuries may still be well and truly backed, their markets are becoming more illiquid than ever before in the US$23.7 trillion market.
From Japanese pension funds and life insurers to foreign governments and U.S. commercial banks, once unflappable buyers of U.S. Treasuries are stepping away, led by the biggest buyer of them all – the U.S. Federal Reserve.
With the Fed upping the pace at which it plans to offload Treasuries from its balance sheet to US$60 billion a month, the once deep and liquid Treasury markets are becoming an increasing source of concern and volatility.
If one or even two steadfast sources of Treasury demand were to pull back, their absence may have gone unnoticed, but all the buyers, all at once, against a backdrop of tepid demand at recent Treasury auctions and markets start to take notice.
Benchmark 10-year U.S. Treasury yields have already soared to 3.95%, while the 30-year sits at 3.94%, a mild inversion, but reflective of heightened recession expectations.
While some investors may be expecting the Fed to swoop in and stabilize Treasury markets, the way the Bank of England intervened to shore up gilts when the pound all but collapsed against the dollar, the Fed has far less wiggle room if it remains resolute in its fight against inflation.
Making matters worse, Japanese pension funds are seeing costs for hedging currency risks on Treasuries soar in tandem with the dollar at a time when Tokyo may need to start selling its hoard of U.S. Treasuries to further prop up the yen.
But U.S. households and hedge funds are finding Treasuries attractive now, betting that the Fed will tip the economy into recession and taking advantage of multi-decade high yields.
It’s unlikely that non-traditional sources will be sufficient to make up for the shortfall of demand in Treasuries and such bets also assume that the Fed is nearing the nadir of its policy peak, none of which is a given.