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When Janet Yellen told former Alphavillain Colby Smith that she didn’t see signs of Treasury market “dysfunction” despite the sell-off, it prompted a glut of considered responses from some of the internet’s bond savants.
The reality is that the Treasury rout — although chunky — DOES seem to have been remarkably orderly? Whispers of some hedge fund getting whacked usually come thick and fast at times like this, and the lack of such rumours since the summer have been noticeable (and a little disappointing).
There could of course still be some bodies that float to the surface, but the New York Federal Reserve’s Michael Fleming has now done some more data grunt work to show that the Treasury market’s liquidity has indeed been . . . fine, with some caveats.
We find that liquidity worsened abruptly In March 2023 after the failures of Silicon Valley Bank and Signature Bank, but then quickly improved to levels close to those of the preceding year. As in 2022, liquidity in 2023 continues to closely track the level that would be expected by the path of interest rate volatility.
For example, here are the bid-ask spreads for various benchmark Treasuries (zoomable version):
More worryingly but in line with what you’d expect with the Treasury market’s ongoing evolution towards more algorithmic trading, the depths of the order books remain below pre-pandemic levels, but have recovered fully from the March 2023 dive (zoomable version):
Another sign of the Treasury market’s deteriorating liquidity is that the estimated price impact of a big $100mn Treasury trade has also climbed noticeably since 2021.
But the current picture hasn’t changed much over the past year. That bigger trades make a bigger than usual splash makes sense given how volatile the Treasury market has been since the Fed started jacking up rates (zoomable version):
Still, “continued vigilance” is needed, Fleming concludes.
While Treasury market liquidity has not been unusually poor given the level of interest rate volatility, continued vigilance by policymakers and market participants is appropriate. The market’s capacity to smoothly handle large trading flows has been of concern since March 2020, as discussed in this Brookings paper. Moreover, new empirical work shows how constraints on intermediation capacity can exacerbate illiquidity. Careful monitoring of Treasury market liquidity, and continued efforts to enhance the market’s resilience, are warranted.
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