Bond market unease poses greatest risk for next financial crisis

Kevin Yin is a contributing columnist for The Globe and Mail and an economics doctoral student at the University of California, Berkeley.

On Tuesday, bond yields rose across the developed world. European, Japanese and British yields surged to highs not seen in decades as Iran-war escalation fuelled inflation worries and global fiscal sustainability remains a serious concern.

Germany’s 10-year bond yields reached a one-year high, while those on France’s two-year bonds reached a two-year peak. The U.S. 10-year Treasury note touched a 20-month high.

These moves build upon recent worrying developments in the U.S. Treasury bond market.

On Aug. 18, a massive sell-off of long-maturity Treasury bonds sent 30-year Treasury yields soaring to 5.33 per cent, the highest level since 2007. The Treasury Department’s buyback policy introduced last month did little to calm markets because U.S. government debt remains on an unsustainable path, with little effort by the current administration to change course.

What to know about the sell-off in world bond markets

If there is a financial crisis in the next few years, it will likely start in the bond market, and especially Treasuries.

The concern is not simply the collapse of an asset price, but that the collapse affects an asset which serves a unique role in our financial system, one which makes it easier for banks to lend and borrow in large volumes during normal times.

Banks exist to convert short-term liquid liabilities, such as deposits and overnight bank-to-bank loans, into long-term illiquid investments in the real economy, like equities and corporate debt. A financial crisis occurs when those short-term liabilities are all withdrawn at once and banks lack sufficient liquid assets to cover the payments, which spills over into other markets because lending across the economy dries up.

Treasuries are unique in their ability to induce these bank runs.

Since the establishment of deposit insurance, people do not have an incentive to withdraw all their savings at once – the government guarantees that even if the bank is insolvent, their deposits are safe. But banks also borrow heavily from each other in what are called “repo markets,” where a borrowing bank must provide collateral to obtain short-term funding. In the United States, that collateral is overwhelmingly U.S. Treasury debt, with roughly 70 per cent of repo transactions collateralized by Treasury securities. That means that more than two-thirds of the most important source of U.S. bank liquidity depends on a continued belief in the safety of Treasuries.

Bank runs, as opposed to mere bursting of asset bubbles, leave the most lasting damage, as both the Great Depression and the 2008 financial crisis demonstrate. The common belief that banks failed in 2008 purely because they held poor-quality assets is incorrect – losses on mortgage bonds were actually relatively small. As research from Yale economists Gary Gorton and Andrew Metrick shows, it was instead because many of these mortgage-backed securities served as collateral in repo markets – and the resulting inability to borrow once that collateral became suspect – that allowed the fall in asset prices to turn into a historic global financial crisis.

If the Treasury market fails, banks cannot borrow from each other, and stop lending to businesses that have nothing to do with Treasury debt. This spillover nature of banking crises is why the severity and duration of the 2008 recession dwarf mere stock market crashes like the dot-com bubble.

Debt haunts all developed economies, but the United States is unique in the scale of its borrowing and its position at the heart of the global economy. Washington has made little effort in past years to correct its debt path, leading to a slow-moving but nonetheless rising risk of a large sell-off. There is evidence to suggest that Treasury bonds, once considered among the safest and most liquid assets in the world, are starting to lose their appeal as a result. The convenience yield – the extra return investors were willing to forgo to hold Treasuries relative to other safe bonds like German bunds – became negative across maturities. People now demand higher returns to hold Treasuries than comparable safe assets.

Moreover, the financial system has changed dramatically since 2008. A byproduct of the wave of financial regulation that arose from that crisis was a shift in who holds Treasury bonds. Once held largely by dealer banks, capital regulations on dealers have forced a greater share of Treasuries on to the books of hedge funds and mutual funds, who are far more easily spooked. In March of 2020, for example, when the COVID crisis hit, long-maturity Treasuries were sold en masse, with a large portion of these sales coming from hedge funds and mutual funds.

Any asset price crash would be damaging for the economy. But because of the unique role of U.S. government debt in the global financial system, it is the government bond market that should keep us up at night.