Council on Foreign Relations' Rebecca Patterson on dysfunction in the treasury markets

Summary

• The market's reaction to the current pause in conflict is fundamentally different from prior pauses, with investors now realizing supply chain risks are cumulative and non-linear, worsening with duration.
• The risk assessment framework involves three dimensions: Duration (a prolonged closure of the Strait of Hormuz), Breadth (geographic escalation or broader commodity disruptions), and Policy Response.
• Specific, underappreciated supply chain exposures highlighted include fertilizer, aluminum alloy (~25% of global supply transits the Strait, critical for auto, beverage cans, and aerospace), and helium for semiconductor manufacturing.
• The conflict is shifting market focus toward inflation risks from commodity disruptions, rather than growth risks, potentially altering the policy outlook.
• Early signs of deteriorating market depth and increased auction tails in the US Treasury market suggest a growing risk of dysfunction.
• A potential, albeit early-stage, market implication is that the Federal Reserve could be forced to inject liquidity (tactical QE) to ensure market functioning, even in a tightening cycle, mirroring the UK's 2022 response.