Illiquidity without dysfunction

The past decade has been a bit of a seminar on different market conditions for US Treasuries.

We’ve had 1) good market liquidity and function in the zero-rates era, 2) good liquidity and dysfunction during the flash rally, and 3) illiquidity and dysfunction around the Covid-19 shutdowns and reopenings.

It now looks like 2022 has brought a new combination: Illiquidity paired with decent market function.

JPMorgan’s rates strategists point out in a note this week that market depth has declined significantly in the past year:

. . . market depth has declined about 60% over the last year and is sitting at levels only seen in late-2008/early-2009 at the tail end of the GFC and in spring 2020, coming out of the global COVID-19 lockdown. Increased Treasury curve dispersion also alludes to weakened liquidity conditions.

That echoes a post from the New York Fed’s Liberty Street Economics blog, which found a similar decline in market depth, and a “modest” widening in bid-ask spreads:

And a rise in the price impact of trades:

So it’s been more expensive to trade, and tougher to move paper in size.

Notably, however, there haven’t been severe dislocations like those seen around the unusually rough 7-year auction in 2021, or the early days of Covid in 2020.

Both JPMorgan and the New York Fed point out that the main driver of the illiquidity is good old-fashioned price volatility. That’s the type that comes from fundamental economic factors and Fed policy, not global investors panicking over a pandemic and fleeing to dollar markets. In other words: Duration risk has returned to Treasuries.

Back to JPMorgan:

When we take a step back, it’s clear monetary policy uncertainty and the associated increase in volatility propelled the declines we’ve seen in various measures of liquidity this year, but there has also been an overlay of market structure changes which leave these measures at lower levels than we would otherwise expect. However, unlike prior episodes of similarly low liquidity, we do not think we are in the midst of a crisis, because the Treasury market continues to function in relatively normal fashion. As we can tell, there is no discernible liquidity preference in on-the-runs versus off-the-runs . . . On-the-runs trade with a premium relative to their near off-the-run cousins, but these levels are not out of line with average levels observed over the past 15 years, and do not show any signs of distress, in contrast to early-2020 and late-2008.

And some measures of market liquidity don’t look nearly as dire:

Dealers are warehousing more Treasuries, too! “Inventories have risen somewhat in 2022,” the bank writes.

Over the longer term, dealers’ holdings haven’t grown nearly as much as the market — that’s where the hedge funds have stepped in. But we at Alphaville are old enough to remember when regulations and high levels of Treasury issuance were supposedly going to cause primary dealers to stop making markets altogether.