(Bloomberg) -- By the standards of March 2020, last week's whiplash in the U.S. Treasury market may not look like much, but it's a mistake to ignore it, Bank of America strategists are warning.
The extreme yield-curve flattening that occurred as short-term rates soared -- pricing in an earlier start to Federal Reserve rate increases in response to elevated consumer inflation -- caused sharp losses for several rates-focused leveraged funds, impairing their risk-taking capacity, Mark Cabana, Ralph Axel, and Meghan Swiber wrote in an Oct. 29 note.
“Liquidity strains are currently localized to the Treasury market but could spillover into other markets,” they wrote. Illiquidity in inflation-protected Treasuries is particularly worrisome, as “sharply higher real rates may pose a threat to risky asset values.”
The Treasury curve flattened during October as surging energy prices stoked inflation fears and reinforced expectations that the Fed will lift policy rates as soon as next year. Last week, the curve inverted at the long end, as the yield on the 30-year note slipped below the 20-year for the first time.
While that's the clearest illustration of “still fragile” Treasury market conditions, the seven-year sector, inflation-protected Treasuries and two-year note futures also experienced “deterioration in liquidity,” the strategists wrote.
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The Treasury auction size reductions that are expected to be unveiled on Wednesday will help, but aren't sufficient, Bank of America says. Treasury market size “has outgrown dealer ability to effectively intermediate risk,” and calls for an official-sector role as dealer of last resort.
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