Stocks Could Fall 25% As Treasury Liquidity Crisis Risks Spillover

• The $24 trillion US Treasury Market is experiencing a liquidity crisis, which could lead to stock market collapse.
• James Demmert warned that the Treasury liquidity is showing signs and symptoms of weakness that are not present since the Great Financial Crisis.
• “A liquidity crisis could most likely prolong the current bearish stock market to deeper levels, in the range of 20-25% or total 50% for the year.”

Analysts believe that a liquidity crisis is developing within the US Treasury market worth $24 trillion. This turmoil could lead to stock losses and financial markets being more severely affected. 

The big swings in bond yields are due to a lack liquidity. Investors selling Treasuries and buying them have created a wider price gap. Trades that haven’t moved the market in the past are now creating volatility. The Fed rate hikes are putting pressure on rates-sensitive growth stocks, which are more vulnerable because borrowing costs are rising.

In fact, Treasury liquidity shows signs of weakness unlike any since the Great Financial Crisis, said James Demmert, managing principal at Main Street Research. 

“One has simply to look back at 2008 or the pandemic to understand the seriousness of a liquidity freeze — particularly in the US Treasury market — which is deemed to be the most liquid market in the world,” he said. A liquidity crisis would most likely increase the stock market’s current bearishness to deeper levels, in the range of 20-25% or 50% for the entire year.

The liquidity crunch is occurring as the largest buyers of US Treasuries are resigning. Japan, for example, has been historically a major buyer of US debt. However, it has recently sold assets in dollar to support the dollar’s rise. The Federal Reserve has stopped buying bonds and is shrinking its balance sheets. 

Large institutions are less likely to be Treasury market-makers because of the so-called Supplemental Leverage Ratio, which requires them to raise more capital and increase their reserves.

Analysts anticipate the government to act. OANDA’s senior market analyst Ed Moya indicated that the Treasury Department would have to buy back old securities and replace them in larger current securities. Meanwhile, the Federal Reserve could modify its standing repo facilities.  

Janet Yellen, Treasury Secretary, recently admitted the possibility of buybacks following a survey of Treasuries dealers about a possible program.

There are many stakes, not only in the stock market but also across all financial markets. Demmert stated that high-yield bonds will likely be affected, while fixed income of low quality would feel the brunt. 

According to Ralph Axel of Bank of America, the “declining liquidity” and “resiliency of Treasury market arguably pose one of the most serious threats to global financial stability, possibly worse than the 2004-2007 housing bubble.”

He also said that the potential spillover effects could be seen in emerging markets and consumer and business confidence. If US Treasury trading were to stop, all corporate, household, and government borrowing in securities or loans would cease.

The note stated that while it sounds like science-fiction, it was a real threat and has taken a lot of people-hours over 10 years without any output from regulators or legislators.