bonds Markets volatility

Liquidity May Be Disappearing In The Most Liquid Market On Earth

"In our view, the significant drop in rates market liquidity is not temporary".

Back in August, when bond yields were plunging amid an acute growth scare, escalating trade tensions and convexity flows (with the latter creating something of a “false” recession optic, as hedging activity exacerbated the situation, driving long-end yields inexorably lower, thereby turbocharging the bull-flattening impetus), we talked quite a bit about the role of lackluster liquidity in driving up rates vol.

During a client presentation in late August, JPMorgan’s Josh Younger documented the extent to which fundamentals explained “less than half of the move in rates and inversion of the yield curve”. On his estimates, the rally in bonds was attributable to a “combination of positioning, hedging activity and poor liquidity conditions”.

Younger rolled out a series of charts, including the following rather stark visuals, one of which plots the deterioration in market depth and price impact atop 3M10Y vol.

As you can see, August stuck out like a sore thumb.

“Market depth is much worse than a typical August, reflecting in part a pull-back from the high frequency market makers that dominate liquidity provision in Treasury markets”, Younger wrote.

Read more: The Truth Behind Plunging Bond Yields

That’s a good set up for some fresh commentary out of BofA’s Carol Zhang, who, in a note dated Friday, flags a “sharp and sustained drop in liquidity” in rates markets.

Zhang uses CME’s liquidity tools, which we’ve cited here on a number of occasions, including in a series of posts from December (ex., Depth Charge, Gamma Gravity And A Dark, Twisted Fantasy Come True).

“Since August 1st, transaction costs have more than doubled from long term averages and book depth has dropped about 20% from its peak”, Zhang observes, on the way to cautioning that recent changes are “more severe than in Q4 2018 and February 2018”. Even more notable is that the phenomenon is more pronounced in Treasurys than it is in equities and FX.

(BofA, CME)

What are the symptoms of this “disease”, as it were? Well, for one thing, ranges are wider, pointing to “gappy” markets. The chart in the right pane above illustrates that.

Meanwhile, thanks in part to the flood of supply, auctions are now “risk events as opposed to liquidity events”, Zhang frets. The following chart shows the disturbing trend from July onward.


And then there’s the old liquidity-volatility feedback loop, a kind of chicken-egg problem, if you like. As is the case with equities, volatility and market depth feed off each other.

“A sharp drop in liquidity translates to higher realized volatility [but] the causal relationship is not entirely clear”, BofA’s Zhang writes, adding that “higher volatility in the rates market has contributed to lower liquidity, or vice versa – but it is likely a combination of the two”.

Correct. They are inextricably bound up, and in equities, that linkage (and the way in which it interacts with systematic flows) has been at the heart of most major selloffs over the past two or more years.

As alluded to above, HFTs play a major role in this.

“Low latency participants have grown to represent a majority of liquidity provision in US rates markets, but their presence is vol-dependent”, JPMorgan’s Munier Salem wrote in August, when HFT participants were responsible for an “outsized share” of the observed drop in liquidity.


For their part, BofA reminds you that liquidity concerns are nothing new, and have been variously discussed and debated in the context of virtually all asset classes.

With that obligatory nod to the ubiquity of this discussion out of the way, Zhang says “a fundamental change in risk appetite may be the new trigger causing the sustained drop in liquidity”. Here’s why:

Since the beginning of August, headline risk from Fedspeak, trade wars and Brexit has significantly escalated and become increasingly difficult to time and anticipate. Higher intraday volatility likely jeopardizes some systematic and high frequency trading strategies, resulting in a sharp pullback from this community. Meanwhile, despite lower market depth and higher transaction costs, Treasury trading volume has increased by 13% yoy, based on SIFMA data – evidence that investors have been eager to add duration due to material shift in the economic outlook.

Throw in reticent dealers who are cautious about how they use their balance sheets and you end up with a recipe for what BofA says could be a “regime change”.

“In our view, the significant drop in rates market liquidity is not temporary”, the bank says, adding that it should persist at least into year-end.

With myriad macro catalysts on the horizon (starting next week) and 10-year yields trading in a fairly narrow range since mid-month, one wonders if some dramatics may be in store.

“Bond markets have been in a holding pattern since the start of last week; the average trading range across the curve over that period has been one of the tightest of the year at roughly 9 bps”, Bloomberg’s Cameron Crise wrote Friday. “Many of the range expansions from similarly quiet periods have been pretty violent, so it’s not hard to envisage quite a few fireworks” going forward.


3 comments on “Liquidity May Be Disappearing In The Most Liquid Market On Earth

  1. vicissitude says:

    Re: ” thanks in part to the flood of supply, auctions are now “risk events as opposed to liquidity events”, Zhang frets. The following chart shows the disturbing trend from July onward.”

    Who knew that an on-going tsunami of Treasury issuance would be a problem? Who could have guessed that if Treasury screwed up the way it normally issues debt in a regular and predictable pattern, there would be a problem?

    Random tidbit: Management and Performance Challenges Facing the
    Department of the Treasury (OIG-CA-20-005

    To further complicate matters, Treasury must also operate in the repeated cycle of budget and debt ceiling stopgaps. Legislation was passed in February 2018 to suspend the statutory debt limit
    through March 1, 2019.6 Because no long-term solution had been found, the U.S. debt limit was
    reinstated at $22 trillion on March 2, 2019. When the statutory debt limit was reinstated, Treasury
    immediately implemented extraordinary measures to prevent the United States from defaulting on
    its obligations. Measures included (1) suspending State and Local Government Series securities
    sales, (2) declaring a “debt issuance suspension period” which suspended additional investments
    in the Civil Service Retirement and Disability Fund and Postal Retiree Health Benefits Fund, and
    (3) suspending investment in the Government Securities Investment Fund of the Federal
    Employees’ Retirement System Thrift Savings Plan. In July 2019, Treasury informed Congress
    that these extraordinary measures would be exhausted before September 2019. Consequently,
    legislation was passed to suspend the statutory debt limit through July 31, 2021.7 While the debt
    ceiling has been lifted, it is only temporary as Congress has yet to resolve unfinished business
    when it comes to the Nation’s debt, and the long-term sustainability of the large programs.
    Although not included as a top open recommendation in its April 2019 letter to the Department,
    GAO raised the same concerns to Congress in its July 2015 report8 with the approach to managing
    the federal debt limit and its impact on Treasury’s borrowing costs and the need for alternative

    Random old news: The national debt reached $22.01 trillion in January, exceeding $22 trillion for the first time in history.

    Although the United States has maxed out its borrowing limit, experts say it will be months before it really begins to hurt. The Congressional Budget Office said last week the United States in the interim can rely on “a large inflow of tax revenues” in April as well as extraordinary measures to continue financing federal activities for a few months.

    Those measures will only net enough money for a short period of time. The CBO analysis predicted the Treasury, without a raise in the debt ceiling, will run out of money by the end of September.

  2. It might also be reasonable to assume that the Federal Reserve’s 24 Primary Dealers each have an HFT arm who used to provide steady flows of liquidity to the “rates” market. But with increasing volatility and higher headline risk/uncertainty, they may be loath to stay in for longer terms…especially if it seems that rates may not drop forever. Cash in the hand may be worth more than a few twittering basis points in the bush.

  3. Anonymous says:

    Still the most liquid securities market in the world… far.

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