At the center of Washington’s effort to manage America’s debt are regular sales of new Treasury bills. For all involved, these are ideally little-noticed happenings.

But weak demand for some recent auctions is raising concerns about how smoothly the government will be able to finance its ballooning debt in the years ahead with higher interest rates and record debt levels on the horizon for the foreseeable future.

Any serious problems are likely a while off, with multiple bids often still on the table for every bond the Treasury aims to sell. But questions about precisely why this current volatility is happening are complicating the debate about reforms that might be needed in years ahead.

Part of the answer is clearly a supply-and-demand issue as a flood of new Treasury bills ($20.8 trillion in issuances so far in 2023) enters a more unstable market.

Experts point to a range of possible explanations for the weaker demand. One reason often cited is aggressive monetary policy tightening that has pushed interest rates to a 22-year high, opening new opportunities for investors to look for higher returns elsewhere. Another is traditional bond buyers who may be less certain of US Treasuries as a safe haven following a series of downgrades of US creditworthiness.

But beyond the current market forces, there is a growing debate about the structure of the bond market itself and whether the “plumbing” of how America’s government makes its books work is up to the task. The concern is whether a confluence of all these factors could lead to economically calamitous failed auctions in the years ahead.

“It’s a matter of national economic security,” says Darrell Duffie, a Stanford professor whose research on dealer balance sheets points to the potential of a lessening of “Treasury market functionality” in the years ahead.

His work — complete with a presentation this summer at the Jackson Hole Symposium — has gained the attention of officials in Washington as he’s likened the problem to a long-delayed but deeply needed public works project.

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“This is the method by which the government funds itself,” he noted in a recent interview. “And if you don’t fix it soon, then you’re inviting a disaster.”

‘All the earmarks of a problem’

For the Treasury Department’s part, Janet Yellen and her aides have monitored the mechanical issues but downplay any link between existing structural issues and the volatility of 2023.

“It is worth emphasizing again that the recent increases in term premiums and volatility do not appear to be because of technical market functioning issues; rather liquidity conditions have held up well,” Treasury Undersecretary for Domestic Finance Nellie Liang told a roomful of market participants last month at the 2023 Treasury Market Conference.

The administration has also launched an interagency working group to track Treasury market functionality with senior officials from Treasury, the Federal Reserve, Securities and Exchange Commission, and more gathering regularly.

This group, a Treasury official told Yahoo Finance, is focused on “efforts to enhance the resilience of this critically important market are broad based and long term in nature.”

What all sides agree is that a further ratcheting up of Treasury market volatility — no matter the underlying cause — could be felt all across the economy.

Mark Zandi, chief economist of Moody’s Analytics, says the scenarios get scary quickly and could “quickly engulf the stock market and mortgage rates and lending rates and it could have much significant, broader implications.”

He notes that some current signals have “all the earmarks of a problem,” likening the current situation to a yellow flare that could be upgraded to red if things continue without reforms.

A range of ideas to increase stability

Treasury market stability has periodically moved to the front burner in recent years, including a COVID-era liquidity crisis known as a “dash for cash” that required the Fed to intervene.

This time around, the SEC is currently in the process of pushing two changes to try and address at least some of the technical issues.

One SEC push, which was finalized just this week, would push more bond trading to what are known as central clearing platforms.

These platforms, advocates say, make markets safer because of the additional backing they mandate for trades between market makers.

Commissioner Jaime Lizárraga lauded the changes in a statement, noting they would “help prevent market disruptions, reduce the need for Federal Reserve interventions, and strengthen market confidence.”

Duffie hails the changes around central clearing platforms as a key step forward but warns they alone “won’t be enough to break the back of the problem.”

Another idea under consideration is a proposed rule aimed largely at the hedge funds that have taken an increasingly prominent role in bond markets. The change would require some firms to register as broker-dealers and be subject to tougher capital and liquidity requirements if they want to keep playing in the market. It was first proposed this March.

In a new letter released Friday, Senate Banking Committee ranking member Tim Scott (R-S.C.) raised concerns that the reforms could exacerbate the plumbing issues and may cause some some to exit the Treasury markets entirely.

“Fewer participants in the Treasury markets will also lead to a potentially dangerous reduction in liquidity in those markets,” he wrote.

This rule is still being debated and is widely expected to be refined in the months ahead to address Wall Street concerns about exactly which firms will be subject to the new requirements.

At issue is whether a wide swath of market participants would fall under the new requirements or if it could be more targeted to a smaller sliver of firms that act as large-scale liquidity providers but are not currently subject to the provisions.

A focus on transparency

A broader issue — both outside experts and Treasury officials agree — is transparency in the bond markets.

Transparency comes up often among experts, with Zandi citing the opaqueness of the market as a structural risk. “If something goes wrong [you could see a quick succession of failures] and that only happens in opaque markets that are not transparent,” he says.

Treasury officials have often focused on transparency as a priority and are moving forward on gradual changes to the market. “We’ve been steadily walking down this path,” Liang said recently, citing a policy change this year from weekly to daily reports of things like secondary market trade counts and average prices.

The recent change marks a notable uptick in transparency with more granular public dissemination of secondary market trading data possible in the months ahead following a review process.

Professor Duffie says even more muscular fixes might be needed — especially around price transparency.

The current system could discourage traders, he says, because buyers must rely on dealers for price quotes with no point of comparison.

“You might end up not trading as much as you would if you could see the prices,” he says, calling such a move “another positive for market liquidity.”

As for further changes to the system, Liang told market participants in October that “we’ll consider possible next steps for additional transparency” after studying the effects of current changes.

Either way, this plumbing issue is likely to only grow in prominence in coming months.

“This is suddenly on our radar much more than it was before,” said Maya MacGuineas, president of the Committee for a Responsible Federal Budget, in a recent interview noting the concerns that small tremors in this arena could escalate quickly.

She adds that “shifts could happen very abruptly so I sit on the edge of my seat in a way that I never have before about how the Treasury issuances are going to go.”

Ben Werschkul is Washington correspondent for Yahoo Finance.

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