Troubles Percolate in the Plumbing of Wall Street

While most investors have been focused on the rapid decline in the stock market, which had its worst day since the crash of 1987 on Thursday, a different drama is going on behind the scenes on Wall Street — potentially with bigger implications for the economy.

The swift, global spread of the coronavirus has chipped away at one of the cornerstones of the financial system: the vast market for bonds, where companies and governments go to borrow money to fund operations. Wall Street banks, as well as sophisticated investors such as pension funds and hedge funds, trade these bonds, including the government debt that is considered among the safest assets in the world: United States Treasuries.

But in recent days, as fears of a pandemic have escalated, the market for Treasuries has experienced a liquidity problem — meaning that the buying and selling of this kind of debt at reasonable prices has suddenly gotten a lot tougher. That, in turn, made already nervous investors even more frantic on Thursday, when the S&P 500 index plunged so far and so fast that trading was temporarily halted. Stocks closed down 9.5 percent, the worst performance since Black Monday more than three decades ago.

The drama in the Treasury market prompted the Federal Reserve Bank of New York to step in on Thursday, saying that it would quickly offer banks $1.5 trillion in funding, via short-term loans, to keep the bond markets functioning smoothly.

That decision illustrates just how central the Treasury bonds are to the economy. They form the bedrock of the entire bond market, because interest rates on all types of bonds are set based on Treasury yields. Any signs of distress involving these bonds — a rare occurrence — means bigger problems could be underfoot for the financial system.

For instance, it could mean borrowing costs are higher than they should be for local governments trying to raise money, homeowners trying to refinance mortgages and businesses trying to fund their operations.

“If you don’t know where the safest asset in the world is, it becomes next to impossible to figure out where everything else is,” said Rick Rieder, chief investment officer of global fixed income at BlackRock.

Even in a crisis, there is a certain logic to how the markets behave. The U.S. government’s guarantee on its bonds makes them the best alternative to holding cash, so investors tend to buy more of these bonds at the first sign of trouble in the stock markets. Higher demand for these bonds makes their prices go up, which pushes down their yields because there’s an inverse relation between bond prices and the return they generate.

That was the case last week, when yields fell to record lows as stock prices slid amid worsening news about the coronavirus outbreak.

But things began changing this week as investors sold Treasuries too, upending the conventional wisdom and causing prices of those bonds to plummet.

“When things go bad, Treasuries rally, and if they don’t, that is incredibly problematic,” said Ajay Rajadhyaksha, an analyst with Barclays in New York and a member of the Treasury Borrowing Advisory Committee to the Federal Reserve Bank of New York, a group of top Wall Street executives who advise on conditions in the Treasury market. He added, “That’s when you begin to get concerned about whether markets are breaking down.”

On Wednesday afternoon, investors across Wall Street reported that Treasury debt, especially certain kinds of older bonds, was becoming hard to trade. Bond yields swung wildly. A huge gap emerged between what buyers of bonds were offering and what sellers were charging.

The mismatch could be temporary. Some big investors, which can hold billions of dollars’ worth of Treasuries, may be selling to avoid further volatility. Some hedge funds that make big bets on typically minuscule movements of Treasury yields have also responded to the enormous swings by dumping their holdings of government debt.

But it’s causing a problem for banks, whose trading desks buy and sell these bonds and act as the middlemen of the market. In a highly liquid market, banks are able to match buyers and sellers easily, because there are only very small differences in the prices sellers are offering and buyers are willing to pay. But this week, as the difference in prices — the spread — widened, analysts said banks were left holding large volumes of bonds they couldn’t immediately sell. That dissuaded them from buying more, causing the market to dry up.

With few players active, the traders who were buying and selling had an outsize influence on bond prices. Market depth, a crucial measure of Treasury market liquidity, has declined to levels last seen during the 2008 crisis, based on data compiled by JPMorgan Chase.

The situation remained strained on Thursday, although it was somewhat improved from the previous day, said Munier Salem, vice president for fixed income strategy at JPMorgan. “Everyone has pulled back,” said Mr. Salem, who added that he expected things to get better or stabilize. “There’s diminishing capacity for it to get much worse.”

The virus, which has forced sports leagues to suspend play and forced legions of employees — including traders — to work from home, poses challenges that stretch beyond the usual stresses at a time of financial uncertainty. Some strategists suggested the physical distance between traders now working remotely or from backup offices had hampered communication and complicated the smooth movement of Treasuries and other bonds.

The Fed’s decision to step in on Thursday was its latest attempt to steady crucial financial machinery. Earlier this week, it sharply increased the size of the temporary loans it makes to eligible banks and extended many of those loans over a longer period of time. Its Thursday escalation should help to meet the short-term cash needs of financial institutions. The Fed, which has been buying $60 billion in assets monthly, is also shifting away from short-term Treasury bills and toward a wider range of Treasury securities, which could help further reduce market pressure.

Marc Lasry, senior principal of the $10.5 billion investment firm Avenue Capital, said that while he believed the economic slowdown would be relatively short-lived, the anxiety of market participants was understandable.

“When everybody wants to be in cash, as opposed to financial instruments, that’s when you start having issues, and that’s what’s happening now,” Mr. Lasry said.

Kate Kelly contributed reporting.