Fed takes tough stance on bond liquidity, downplays market fears

Tue Jul 21, 2015 1:11am EDT
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By Jonathan Spicer and Michael Flaherty

NEW YORK/WASHINGTON (Reuters) - While Wall Street frets over the ability of bond markets to absorb an approaching interest rate rise, the U.S. Federal Reserve has a message for the industry: deal with it.

The financial industry worries that when the Fed's tightening plans take hold, a sell-off in the massive U.S. bond market could ensue, and be exacerbated by a lack of bank buyers willing to jump in.

Banks, including primary dealers who act as market makers for U.S. Treasuries, have slashed bond inventories in the past few years in response to tougher capital requirements, reducing a liquidity buffer for the fixed income market.

Private and public comments by Fed officials show that they do not share Wall Street's degree of concern about liquidity, and do not believe that capital rules are solely to blame for the bond market’s growing tendency to seize up.

Effectively, regulators are telling the industry it is the responsibility of banks, funds and other market players to protect themselves.

"It's hard to find any financial market player who doesn't talk about being concerned about potential liquidity issues," Eric Rosengren, president of the Boston Fed, which oversees many of the country's largest asset managers, told Reuters.

"So it would surprise me if I found that people were using a particular model and didn't use any intuition about what goes into those models, and what might happen if everybody blindly uses those models."

At last week's congressional hearings, Fed Chair Janet Yellen resisted pressure by Republicans to acknowledge that new capital rules were destabilizing markets.   Continued...

U.S. Federal Reserve Board Chair Janet Yellen delivers her semi-annual report on monetary policy before the Senate Banking and Urban Affairs Committee, on Capitol Hill in Washington, July 16, 2015. REUTERS/Mike Theiler