Treasury Liquidity Squeezed as Dealers Shut Off Machines

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As soon as Charles Comiskey saw what was coming, he turned off his machines.

It was still early in the New York trading day on Oct. 15 and investors were already pouring into U.S. government bonds as global financial markets from Asia to Europe buckled. Because yields were falling so fast, Comiskey, the head Treasury dealer at Bank of Nova Scotia, realized that he ran the risk of being stuck with losses or unwanted inventory if his computers automatically generated quotes to buy and sell with customers.

So for about half an hour, as yields on 10-year Treasuries tumbled below 2 percent in the biggest plummet in five years, he executed client orders individually over the phone.

“It was a very high stress, very fearful trade,” Comiskey, whose firm is one of 22 primary dealers that trade directly with the Federal Reserve, said from his office in downtown Manhattan. “Once we recognized things started getting out of control, we shut it off immediately. It was like turning the clocks back to pre-electronic trading” in the 1990s.

Bank of Nova Scotia was hardly alone in taking steps to protect itself in one of the most volatile trading days since the collapse of Lehman Brothers Holdings Inc. in 2008, showing how regulators’ efforts to rein in risk-taking among the world’s biggest banks is causing disruptions in what is supposed to be the deepest, most liquid market in the world -- that of U.S. Treasury securities. Because dealers have cut back so much in recent years, concern is deepening that parts of the market have become less efficient in times of turmoil.

Default Haven

Unlike other securities such as corporate bonds, Treasuries are backed by the full faith and credit of the U.S. government, which has never repudiated its obligations.

The $12.3 trillion market is also the world’s biggest for government bonds, exceeding the size of the next two nations combined and making it the haven of choice for investors seeking safety. During the credit crisis in 2008, Treasuries soared 14 percent, while both investment-grade debt and junk bonds sank.

JPMorgan Chase & Co., a primary dealer, estimates the amount of U.S. debt available to trade at one time without moving prices has plunged 48 percent to $150 million since April. The measure is based on the average size of the best three bids and offers that go through the New York-based bank’s trading desks on a weekly basis.

That, in turn, may undermine the U.S. government’s cost to borrow if investors begin to doubt whether they will still be able to buy and sell Treasuries on a moment’s notice.

Widening Gap

Another consequence of a lack of liquidity and rising volatility was the widening of the bid-ask spread, or the difference in prices or yields between buyers and sellers.

The gap on 10-year notes reached 0.26 basis point versus an average 0.19 point this year and compares with 0.17 point over the past 15 years, according to data compiled by Bloomberg. One basis point equals 0.01 percentage point.

“You’re widening your spreads out and you invoke more of a premium in this situation,” Sean Murphy, a trader at Societe Generale SA, said by telephone from New York. Murphy, who has been trading Treasuries since 1986, said liquidity constraints on Oct. 15 were similar to what happened after Lehman failed in 2008 and Long-Term Capital Management collapsed in 1998.

Diminishing market depth and a surge in volatility were both on display on Oct. 15.

Gripped by concerns over another recession in Europe, slowing economic growth in China and the spread of the Ebola outbreak, demand for haven assets soared. Buying also picked up as bearish traders pushed back their wagers for how soon the Fed would raise interest rates in the face of a global slowdown.

‘Thin Line’

Dealers contended with the onslaught by offering fewer bonds at a given price and demanding wider spreads, which curbed liquidity and made trading more costly.

“There’s a thin line to keeping the customer happy while also giving a level that you can at least get out of without taking a big loss right away,” Jason Rogan, managing director of U.S. government trading at Guggenheim Securities LLC, a New York-based institutional brokerage, said Oct. 22. Rogan’s firm also turned off its automatic pricing on Oct. 15 because “the market was moving too fast for our prices to keep up.”

Those decisions helped to produce swings rarely seen in Treasuries as trading soared to a record. Yields on the 10-year note tumbled 0.34 percentage point to a low of 1.86 percent that day, with most of that drop occurring in a 10-minute span from 9:30 a.m. in New York, before ending the day at 2.14 percent.

No Immunity

Adjusted for current yield levels, which are close to historical lows, the magnitude of the intraday decline that day has been exceeded only once in the past half-century, according to data compiled by Bloomberg.

“What happened was another manifestation of the world we live in after the Lehman crisis,” Nikolaos Panigirtzoglou, a London-based strategist at JPMorgan, the top-ranked firm for U.S. fixed-income research by Institutional Investor magazine, said by telephone on Oct. 22. “Liquidity dries up quickly when volatility spikes. No market is immune to that anymore.”

In the post-financial crisis era, new rules such as Basel III and the Volcker Rule that limit excessive risk-taking will make the financial system safer, which is more important to regulators than profits from trading, said Simon Johnson, a former chief economist of the International Monetary Fund, who teaches economics at the Massachusetts Institute of Technology.

“We are not going to go back to the highly leveraged go-go days of the mid-2000s when they took risks and blew themselves up,” he said by phone Oct. 24. “It’s not going to happen.”

Capital Requirements

An unprecedented $946 billion of U.S. government debt changed hands through London-based ICAP Plc on Oct. 15, which suggests that concerns over liquidity may be overblown and were due more to the fact buyers couldn’t get the prices they wanted when everyone else wanted to buy at the same time.

Richard Prager, the head of trading and liquidity strategies at BlackRock Inc., the world’s largest asset manager, says regulations are one of the reasons why bond dealers have less incentive to facilitate trades for clients.

To comply with higher capital requirements from the Basel Committee on Banking Supervision, firms with bond trading desks have responded by reducing inventories. Primary dealers have slashed their U.S. debt holdings 56 percent to $64 billion from a record high in October 2013, data compiled by Bloomberg show.

At the same time, supply is being constrained by the trillions of dollars in bonds central banks from the Federal Reserve to the Bank of Japan bought to support their economies.

Failed Test

“The totality of the regulations have had a dramatic impact on the financing market,” Prager said in an Oct. 15 telephone interview from New York.

If confidence in the ability to buy and sell Treasuries erodes further, the risk of bigger disruptions may lie ahead when the Fed raises rates from close to zero in what would be the first increase since 2006, said Nick Stamenkovic, fixed-income strategist at RIA Capital Markets Ltd. in Edinburgh.

That may potentially lead to higher funding costs for the government at Treasury auctions. Yields on the 10-year note, the benchmark for trillions of dollars of debt from home loans to company bonds, have fallen 0.78 percentage point from a high of 3.05 percent this year to end at 2.27 percent last week. In the past decade, the note has yielded an average 3.35 percent.

The yield ended at 2.26 percent today.

“The market could not handle large flows without prices moving massively,” Michael Cloherty, the head of U.S. rates strategy at Royal Bank of Canada’s RBC Capital Markets unit, said in an e-mail. “We took that test Oct. 15 and failed.”

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