Curatia Analysis for Mon, May 22, 2023

Nasdaq: A Trader’s Guide to Navigating Treasury Markets Amid the Specter of a US Debt Default

Jason Dibble Co-Founder, Editor in Chief

Negotiations to raise the US debt ceiling in order to stave off default began cordially, helping global markets remain relatively calm. Those dynamics have rapidly shifted as the deadline approaches, however, stoking volatility that unlocks profit opportunities for savvy traders.

Given repeated bouts of Treasury illiquidity since the start of the pandemic, traders would also be well-served to ensure they're up to speed on the market's hazards and sanctuaries. Our guide to recent Treasury liquidity developments and investing options, sponsored by Nasdaq, can help.

Clear and Present Danger

The S&P 500 rose 1.2% Wednesday after both sides of the aisle voiced what Bloomberg News called “cautious optimism” that the White House and lawmakers could hash out a deal to raise the US debt ceiling and stave off a potential early June default.

That rare moment of bipartisan unity yielded to political drama Friday as Republicans walked out on negotiations. More conflict could lie ahead if discussions follow the precedent of recent standoffs in which both parties have struggled to marshal cohesion among their various factions. A divided Congress could further complicate that mission.

Regardless, recent developments speak to the negotiations’ urgency. President Biden scrapped plans to visit Australia and Papua New Guinea following the weekend’s G7 summit in Japan to return to the US in hopes of resolving the impasse.

A default would send riskier stock and corporate bond markets reeling while paradoxically pushing Treasuries higher in the immediate term as investors fled to haven assets. But the long-term rise in US borrowing costs from a downgrade in its credit rating also figures to send the economy into a tailspin, likely prompting the Fed to slash interest rates.

The likely result would be intense bouts of volatility spawning a whiplash effect across all global markets — a trend that could be foreshadowed in microcosm as debt-ceiling negotiations unfold.

Consequently, financial firms including JPMorgan are setting up war rooms and liaising with clients, partners, and other stakeholders to grapple with the implications of a default. Nomura Global Head of Rates Middle Office and Product Control John Ferraiuolo tweeted that industry trade group SIFMA and financial-technology provider Broadridge have been engaged in similar preparations for weeks.

In the rates realm, concerns over a potential US debt default are compounded by the fact that Treasury markets have repeatedly been buffeted by liquidity issues during volatile stints since the start of the pandemic.

The developments have spurred a variety of proposed or contemplated regulatory reforms including central clearing, dealer registration, enhanced data disclosures, and steps to promote all-to-all trading.

But many market participants have fretted that even those would-be fixes could harm rather than help liquidity by raising trading costs for newly influential market makers, potentially driving them out of Treasury trading.

Instead, some analysts and market participants have implored the Fed to buoy Treasury liquidity by easing capital requirements for dealers. That remedy could face an uphill battle, however, following the March banking crisis that took down several regional banks facing steep paper losses in Treasury holdings.

Moreover, such reforms would unfold over too long a timeline to rescue Treasury markets from debt-default ructions.

Liquidity Solutions

That said, other solutions are offering some degree of near-term relief. International investors lured by higher yields have returned to Treasury markets in 2023, for instance.

In Japan, where rates remain low, traders have also popularized a creative trade that lets them pocket the yield premium longer-dated Treasuries offer over equivalent swaps. The maneuver shields them from Treasury market volatility.

Even the Treasury Department itself is taking steps to restore Treasury liquidity. It announced earlier this month that it would intervene to boost Treasury liquidity with its first buyback scheme in decades. The program will purchase older, often less-liquid bonds from primary dealers in a bid to free up their balance sheets to carry more liquid inventory.

While the decision came at investors’ urging, it will not seek to address liquidity crises specifically. It will also be sized “conservatively” and won’t take effect until next year. As with regulatory reforms, that timing is too late to ease potential default-related liquidity issues.

Investing Options

That leaves traders to mull how they can capitalize on prospective Treasury volatility in the coming days while minimizing the risk of being caught out in an illiquid position.

One possibility is credit default swaps. If the US does default on its debt — an outcome anticipated by 29% of fund managers in Bank of America’s most recent monthly fund manager survey — Treasury CDS holders will receive a payout equal to the difference between the cheapest Treasury bonds in circulation and the one for which they purchased insurance.

Because rapidly rising interest rates have sent Treasury prices plunging since last year, that gap is unusually wide — and the payout therefore potentially huge.

On Wednesday, Bank of America analysts similarly called tail-risk hedges in the form of options on the S&P 500 and gold “cheap lottery tickets” that imply 35-to-1 and 39-to-1 payouts, respectively, if debt-ceiling negotiations stage a repeat of the 2011 crisis. That impasse saw the S&P 500 fall 17% over a one-month span before reaching a resolution two days before the estimated default deadline, or X-date.

For those looking to trade more continuously rather than placing one-time bets, Treasury ETFs that proved their worth as a liquidity haven at the start of the pandemic may offer a preferable alternative to Treasuries themselves.

That’s all the more true since repeated bouts of bond-market volatility have placed a premium on liquidity, ushering in the era of the bond ETF and spurring the creation of a wealth of Treasury funds to meet wide-ranging investor needs.

Among the most popular are BlackRock’s Nasdaq-listed iShares Treasury Bond ETFs at durations of 1-3 years (SHY), 7-10 years (IEF), and 20+ years (TLT). They offer neatly packaged exposure to short-, medium-, and long-term Treasuries, and all boast at least $27B in assets.

BlackRock’s suite of iShares iBonds US Treasury ETFs, also listed on Nasdaq, gives investors robust options not typically associated with ETFs including the flexibility to build bond ladders, pick points on the yield curve, and match the cash flows expected from Treasury investments.

F/m Investments’ innovative suite of single-bond Treasury ETFs meanwhile offers a compelling option for traders looking to capitalize on short-term Treasury moves. They give investors a liquid means of making leveraged bets on falling rates as well as an easy way to short Treasuries.

Collectively, those Treasury ETFs empower investors to avoid the perils of Treasury market illiquidity while betting on virtually any outcome in a potential debt-default crisis or any other stint of Treasury volatility.

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