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.
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.