Liquidity crisis? Amid Middle East conflicts and "Trump's bluster," the $30 trillion U.S. Treasury market signals a warning light

Ask AI · How do former President Trump’s social media remarks intensify volatility in the U.S. Treasury market?

The U.S. Treasury market, with a size of up to $30 trillion, is facing severe liquidity strain, and President Donald Trump’s frequent back-and-forth posts on social media have only made matters worse for the market…

The U.S. Treasury market, with a size of up to $30 trillion, is showing increasingly clear signs of strain, and turmoil in the Middle East has caused the prices of these bonds—supporting the financial system—to swing sharply. Wall Street banks and investors say that although trading is still running smoothly for now, in this global’s largest and most important financial market, the convenience of trading has already taken a significant hit in recent weeks.

The pressure facing the market indicates that some investors are pulling out of Treasury trading. This is because the Iran conflict has triggered the most severe round of volatility since last April, when President Donald Trump’s so-called “Liberation Day” tariff policy announcement jolted the Treasury market. Since the outbreak of the conflict four weeks ago, Treasury yields have seen major swings on many trading days, as investors are re-evaluating how much the skyrocketing oil prices will feed into inflation and affect the Federal Reserve’s rate outlook.

On Thursday, Treasuries were sold off, and the yield on two-year Treasuries—highly sensitive to monetary policy—rose by 0.12 percentage points to 4%. Since the start of this month, the two-year Treasury yield has surged by 0.62 percentage points, marking the worst performance since September 2022, while the Treasury auction of notes at the same maturity held earlier this week also drew a lukewarm response.

Meghan Swiber of Bank of America said: “Investors are still not sure whether we’ve already passed the peak of the conflict; this wait-and-see sentiment leads many people to stand aside.”

Matthew Scott of AllianceBernstein added that, over the past month, “liquidity in interest rates and macro products (that is, how easy it is for traders to buy and sell) has visibly deteriorated.” JPMorgan Chase also pointed to a similar situation this week: the trading size needed to move prices (i.e., so-called ‘market depth’) has fallen, with the decline almost as large as the drop that followed Trump’s announcement of the ‘Liberation Day’ policy.

Investors and policymakers have been closely monitoring the functioning of the U.S. Treasury market because it plays an important benchmark role in global borrowing costs. Even though market functioning has worsened, investors and other market participants say that conducting large trades is still feasible.

James Carter of the asset manager W1M said the decline in market depth is a “natural reaction by market participants when they pull back in the face of external shocks.” He added: “Historically, this situation is often temporary.” Scott of AllianceBernstein noted that because this volatility has forced traders to step aside and wait on the sidelines, market depth in the spot market is down by roughly 40% to 50% compared with before the conflict. According to an executive at a large asset manager, in short-dated bond futures—widely used to bet on or hedge bond price moves—this week’s market depth has plunged by as much as 80% versus the average level this year.

In a report this week, Citadel Securities’ Scott Rubner said the liquidity in the U.S. stock market is also ‘extremely thin.’ He added that when liquidity declines—especially at the top of the order book (representing the best available buy and sell prices)—it “hinders the ability to quickly transfer risk without causing a move.”

Since the outbreak of the conflict, volatility across markets has been rising sharply, but on Monday this week, trading U.S. Treasuries became particularly maddening. In the early hours of that morning Eastern Time, Trump posted on ‘Truth Social’ that the U.S. and Iran held ‘productive’ talks, and then Tehran promptly stepped out to ‘call it out,’ saying no discussions at all had taken place between the two sides.

The turmoil in the Treasury market is so intense that some Wall Street banks have even shut off the screens used for automated quoting, forcing buyers to revert to a slower, traditional trading model based on manual matching. Michael Lorizio of Manulife Asset Management noted that investors had at one point been “unable to price certain Treasuries,” and he said: “After Trump’s post triggered an initial direct shock, you’ll see that electronic trading at the start of Monday morning has effectively ground to a halt. You see dealers shut off the automated quoting function for Treasuries.”

Inflation-protected bonds and short-term Treasuries have been hit especially hard because they are most sensitive to expectations for inflation and monetary policy, respectively. At present, futures traders think that the probability the Federal Reserve will raise rates this year has already overtaken expectations for rate cuts; and before this conflict broke out, the market had already priced in two to three rate cuts.

This week, auction results for the new batch of short-dated Treasuries issued by the U.S. government have also been quite dismal. In Tuesday’s auction of two-year Treasuries worth $69 billion, primary dealers—large banks forced to “take down” the portion of bonds not purchased by investors—took on the largest share since 2022. The same playbook unfolded in Wednesday’s auction of five-year Treasuries worth $70 billion, where dealers bought the highest share since 2024. Thursday’s auction of seven-year Treasuries improved slightly, but by historical standards it remains weak.