Clocking in at around $24 trillion, the U.S. Treasury market is the largest government bond market on earth. Considering its size and scope, one would think that adequate liquidity would be an afterthought. Normally, it is. 

However, the 2022 trading year has been anything but normal, and liquidity in the U.S. Treasury market hasn’t been reliable this year, creating concern among government officials, bond market participants and the broader financial sector.

Problems in the Treasury market crystallized a few days ago when the U.S. government released its twice-annual report on the stability of the American financial system. 

Highlighted in the report—known as the Financial Stability Report—was the revelation that the market for U.S. government bonds has been suffering from inadequate liquidity in 2022. That’s a risk that could spell trouble for not only American banks but also the financial firms that comprise the so-called “shadow banking system” in the U.S.

Illiquidity is a concern for any financial market because a lack of liquidity can be disruptive to the normal functioning of the market, and it can result in atypical pricing behavior. Insufficient liquidity also tends to be accompanied by higher-than-usual market volatility. That type of situation is suboptimal because over-leveraged firms often get exposed when markets behave abnormally. 

The illiquidity observed in the U.S. government bond market (AKA Treasury market) appears to have materialized for several key reasons in 2022. The first relates to what’s commonly known as Quantitative Easing (i.e. QE). At the end of last year, the Federal Reserve began the tapering process—stepping back its purchases of U.S. government bonds.

The Fed had been buying government bonds to help create liquidity in the financial system during the early stages of the COVID-19 pandemic. But as the effects of the pandemic have eased, the Fed has been slowly pulling back its assistance to the economy.

The Fed’s shrunken presence in the bond market has therefore been one of the key drivers of reduced liquidity in 2022. However, the fact that the Fed has also been aggressively raising rates this year has compounded the problem. Bond prices and interest rates share a strong inverse relationship—as interest rates go up, bond prices go down, and vice versa.

So, as the Fed has raised rates in 2022, bond prices have been falling, much to the chagrin of those that own those bonds. Like most markets, when prices go down—especially in rapid, pronounced fashion—liquidity tends to dry up. The same phenomenon was observed in the stock market during the 2008-2009 Financial Crisis.

Beyond those two factors, the bond market is also under pressure in 2022 because of record strength in the U.S. dollar. Dollar strength has forced many foreign countries to defend their currencies against devaluation. In order to fight that battle, some of those countries have been selling U.S. government bonds to build up their currency war chests. 

Together, the aforementioned forces have resulted in lower liquidity and heightened volatility—the latter of which can further exacerbate the liquidity problem.

The U.S. government is also issuing roughly twice as many bonds as it did prior to the pandemic. That’s not necessarily ideal at this time because it means a larger supply of bonds are being forced into an increasingly illiquid market environment.

In a statement released in conjunction with the Financial Stability Report, Lael Brainard, vice chairperson of the Fed, said of current conditions, “Today’s environment of rapid synchronous global monetary policy tightening, elevated inflation and high uncertainty associated with the pandemic and the war raises the risk that a shock could lead to the amplification of vulnerabilities.”

Despite the concerns raised by Brainard, it appears government regulators are currently in wait and see mode because no specific solutions have been offered to this point. 

That said, some Treasury market participants have suggested that the U.S. Treasury buy back older bonds that are still in circulation. Buying these bonds back from the financial firms that hold them would theoretically free up valuable space on the balance sheets of these organizations, and allow them to dedicate more capital to newer bond issues. 

This approach would also technically help narrow the gap in yields that exists between older and newer bonds, which could also assist in lowering overall market volatility. 

If the current problems persist, or get worse, it’s almost certain the government will announce a buyback to help calm the markets, or another solution deemed equally effective. Some market analysts think that the buyback program is already on track to be announced in early 2023.

For now, it’s important for all investors and traders to be aware of this topic because a big dislocation in the government bond market—if one materializes—would almost certainly spill over into other parts of the financial markets.

To learn more about trading the U.S. Treasury market, check out this new installment of Market Measures on the tastytrade financial network. 

For daily updates on everything moving the markets—including U.S. Treasuries and associated yields—monitor TASTYTRADE LIVE, weekdays from 7 a.m. to 4 p.m. CDT.

Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to