Black Cloud of Illiquidity Hovers Over the Bond Market

The failure to identify the cause of the October 2015 "flash rally" remains troubling.

Alarm bells.

William Thomas Cain/Getty

The $13.9 trillion market for U.S. Treasuries is often called the most important in the world. Lawmakers, regulators and investors have always taken its smooth functioning for granted, with rare exceptions such as the bidding scandal that almost sunk Salomon Brothers in the early 1990s. Liquidity, or the ability to buy or sell at a moment's notice, was unquestioned.

All that changed one morning in October 2014 with a dramatic “flash crash” in yields. Rates on 10-year notes ripped sharply lower with no obvious trigger, only to scream back higher in a gut-wrenching 37-basis-point range. It was unprecedented, and it sparked the first government review of the market since 1998.  More than two years later, regulators still don't know what exactly caused it, and the anxiety level among traders is on the rise as the market slumps anew. 

The failure to identify the root of the sudden liquidity collapse remains troubling, despite the absence of a repeat has helped put the issue lower on the list of concerns for investors. In many ways, the voracious demand of central banks worldwide, ultra-low rates and low volatility may have cushioned the deterioration in liquidity, but the problem hasn’t gone away and will increasingly make the market a more perilous place to trade as the Federal Reserve raises interest rates and the Donald Trump administration embarks on its debt and deficit spending programs.

Volumes in the market aren't an obvious caution flag, as they have been relatively stable in the area of $500 billion per day for years. Of course, as a percentage of outstanding Treasuries, turnover has fallen sharply as the amount of bonds grew from $4.7 trillion in 2008. 

The core of the risks lies in the withdrawal of many of the markets key players, namely the bank dealers who formerly dominated the trading landscape. The post-crisis regulatory strictures designed to safeguard the financial system discouraged them from holding big Treasury positions. These banks shrank their positions as much as 80 percent in many cases, and chopped their sales and trading staff.

Many dealers have moved to small trading operations, essentially manning their computer servers rather than interacting and trading with customers. The non-U.S. dealers in particular have withdrawn from full-service activities, as most lacked the size necessary to prosper in a market often cited as the most difficult in the world to make profits due to tiny bid-offer spreads. Anecdotal discussions with senior market-makers suggest a severe lack of depth in the market for off-the-run Treasuries, where volumes have fallen significantly. 

The gradual hollowing-out of the traditional dealer infrastructure opened a path for new groups of bond traffickers, namely high-frequency, algorithm-based and leveraged hedge fund players. 

The Treasury Department's study of the Oct. 15 move showed that the market had become dominated by these lightning-fast trading shops. But they provide moment-to-moment liquidity without actually taking any long-term positions, raising concern that true market depth won't be there when there is another bout of extreme volatility.

More promising in terms of liquidity-provisioning is the entry of very large and well-capitalized hedge funds into off-the-run Treasuries, as we saw with Citadel LLC’s recent announcement. And starting in July, broker-dealers will be required to report their transactions through FINRA’s TRACE system. 

Although critics say this is an unnecessary and costly layer of regulation, proponents point out that the market's 33-year-long bull run may be turning, and the combination of faster Fed tightening, foreign central bank sales and a ballooning deficit could pressure an already-weakened dealer liquidity condition. In the past, all the New York Fed had to do to encourage a bank dealer to shift their behavior was to make a discreet phone call.  That doesn’t work with a hedge fund or a black-box trading engine.

The current slump in the bond market that began in the summer has yet to trigger any severe bouts of illiquidity like those we saw in 2014.  That may be because large institutional and fast money investors are increasingly moving to the Treasury futures markets when they need to shift risk quickly. This has increased the market’s intraday focus on the large futures block trades that are reported with a 10 minute delay by the exchanges.

The consensus among market participants regarding  liquidity risk in Treasuries is that it all comes down to the Fed: When policy makers in Washington get more serious about raising rates quickly,  the functioning of the rapidly changing market structure will be severely tested. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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