Stocks could sink 25% as the liquidity crisis in Treasuries threatens to spill over to other markets, analyst says

The $24 trillion US Treasury market has the potential to plunge stocks as well as cripple financial markets if there is a crisis.

The price gaps between investors buying and selling Treasuries have widened due to a lack of Liquidity. The market is creating more volatility because of trades that didn't move it before. Borrowing costs are already rising on Fed rate hikes.

James Demmert, founder and managing principal at Main Street Research, said that there are signs of weakness in Treasury liquidity.

The US Treasury market is considered to be the most liquid market in the world, and one has to look back at 2008 to understand how serious the freeze is. The current bear market in stocks would most likely be extended to include a total of 50% for the year if a liquidity crisis were to occur.

The largest buyers of Treasuries are pulling back. Japan has historically been a top buyer of US debt, but has recently sold dollar- denominated assets to prop up the slumping Japanese currency. The Federal Reserve's balance sheet is getting smaller.

As a result of the supplementary leverage ratio, big institutions are less inclined to serve as Treasury market-makers.

Some action is expected from the government. The Treasury Department will have to buy back older securities and replace them with larger current ones if the Federal Reserve modifies its standing repo facility.

After surveying dealers of Treasuries about a possible program, the treasury secretary acknowledged the possibility of buy backs.

The stakes are high for both stock and financial markets. High-yield bonds and low-quality fixed income are likely to be hurt.

One of the greatest threats to global financial stability today is the decline in the resilience of the Treasury market.

He said that the spillover effects could extend to emerging markets. Corporate, household and government borrowing in securities and loans would stop if US Treasury trading stopped.

While this sounds like a bad science-fiction movie, it is actually a real threat that has absorbed a large amount of people-hours over the past 10 years with very little output from regulators or lawmakers.