Treasury market liquidity: good but fragile?

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Halloween is still a month away, but here’s a scary chart of Bloomberg’s US Treasury Liquidity Index.

The higher the score, the less liquid the $27 billion Treasury market is. So according to this index – which is derived from how dispersed Treasury prices are from a smoothed yield curve – the US government bond market is now less liquid than it was at the height of the March 2020 chaos.

FT Alphaville has been following this measure as it shows a radically different picture from what analysts and officials are saying and what the headline data seems to indicate. August was the first month in history when the average daily notional amount of Treasuries traded topped $1 billion, up 37% year over year, according to Coalition Greenwich. Treasury futures trading rose by a similar amount.

That’s why this annual check of Treasury market liquidity from the New York Federal Reserve is so timely.

The tl;dr is that bid-ask spreads remain modest – and nowhere near where they were in March 2020 – while market depth remains reasonable, if reduced following the Fed’s rate hike.

As a result, the estimated price impact of the $100 million Treasury transactions is also unalarming. Large trades make more of an impact than before, but the deterioration seems mostly to be caused by higher interest rate volatility, which is now easing a bit.

The author – Michael Fleming, head of capital markets studies at the Fed’s research group in New York – explores the discrepancy between these measures of liquidity and that shown by the Bloomberg index, but mostly shrugs it off:

While the Bloomberg measure has risen recently, it remains well below its peak during the GFC. Moreover, it remained well below the GFC peak of March 2020, even as direct liquidity measures approached GFC levels and the Fed unleashed massive asset purchases to address the dysfunction, which then roiled the market. It follows that the recent behavior of the Bloomberg index appears less remarkable when examined in a longer historical context. The reasons behind the disparate performance of different measures is an interesting area for future research.

This research should probably focus on the underlying composition of the Bloomberg index. Barclays analysts previously noted that the Bloomberg index may have been artificially boosted this summer due to the inclusion of very old 30-year Treasuries, which for various reasons are trading extremely rich in what would normally indicate the shape of the curve yields.

FTAV has another, admittedly more speculative, approach. These types of price dispersion versus fair price indices are supposed to measure liquidity conditions because a lot of bad prices indicate that there is not enough capital in the market to take advantage of them.

But this would seem to be a better measure of fragility rather than liquidity?

In other words, the liquidity of the treasury market might be basically good and perhaps improving, but the underlying fragility of the market is increasing as banks devote less and less of their balance sheets to lubricating it? In that case, we won’t really know how healthy it is until the next shock hits.

Further reading:
— the bond market liquidity trilemma (FTAV)
— People are worried (again) about bond market liquidity (FTAV)