The History Of Treasury Market Liquidity (And Lack Thereof) In One Chart

While we completely disagree with Credit Suisse about the reasons for the total collapse in bond market liquidity (as readers know we blame the Fed - as does the TBAC - and HFTs, while Credit Suisse accuses regulations, even though banks now hold a record amount of fungible bonds implying that unless bank prop desks can trade as FDIC-backstopped hedge funds once again it is simply impossible to have a stable, liquid bond market which is idiotic), we agree about one thing - the same thing we warned many years ago would happen: the total evaporation of liquidity in what was once the world's deepest, most liquid market.

Case in point:

Remember, in any market and certainly bonds, volume is not liquidity or depth. Some more thoughts from Credit Suisse:

Shallower depth at times of higher volatility is at once a symptom and a source of the extreme price moves. Historically, market depth – which we measure as the aggregate bid and ask size for the on-the-run 10y note within 2.5 ticks of best on the other side – has ebbed and flowed with volatility. Surges in volatility typically cause depth to dissipate, whereas stable markets tend to be deeper.

While the core of this inverse depth/volatility relationship has remained in place, the last two years seem to have witnessed somewhat of a break, coinciding more or less with 2013's taper tantrum. While delivered vol moderated in the aftermath of the mid-2013 selloff, depth has failed to return and at this point appears to have been structurally reduced. Early indications are that this has only become worse in the months since the October 15 "flash rally." The only period that saw comparably low depth persist over the last four years was amid 2011's debt ceiling and ratings downgrade in the US and the eurozone crisis (Exhibit 4).

One might be tempted to be long volatility to protect against the possibility for extreme price moves as market depth remains challenged. The risk of doing so is that one will bleed carry, however, as we have seen that there may be long periods of relatively stable markets interrupted by unexpected dramatic moves during extreme illiquidity.

Of course, one may simply be unable to trade out of any profitable volatility hedges if, say, the CME or Nasdaq Options Market decided to close just as the collapse began. Then said "hedges" would be worth precisely, pardon the pun, zero.

And then there is the most famous example of a sudden and total loss of Treasury liquidity: October 15, 2014. Here is what happened.

Still fresh in many participants' minds, October 15 provides a recent illustration of the flighty nature of liquidity and the illusion of market depth. The post-retail sales rate rally that ultimately saw a ~36bp yield range in 10s on the day accelerated as depth disappeared. As some market makers stepped back to avoid being put into significant risk positions, those that continued to provide quotes widened bid/offer spreads, sharply curtailing the depth within a "normal" width of the other side of the market.

Volume spiked at the same time just as market depth was truly beginning to collapse. This resulted in an outsized surge in the number of trades, meaning a diminished average transaction size. That there were more, smaller trades concurrent with the rapid yield move underscores the impact that a collapse in depth has on the magnitude and speed of market reactions.

Finally, whatever the cause, our advice is just to sit back and await the next Treasury flash crash (or smash) because with no change possible, things can and will only get worse.

Comments

[MonetaryApostate]

I guess some people are waking up....

https://lh4.googleusercontent.com/-UPlUXWy9wBE/VVLTkRQNH4I/AAAAAAAAhiY/Y...

[ZH Snob]

they're finding the safe harbor is loaded with mines.

[buzzsaw99]

stocks are safer than bonds and they always go up so what difference does it make if the depth goes to zero? /s

[asteroids]

In 2009 you wondered about the consequences of mal-investment. Well, here it is. You'll know why the bond market blew up.

[polo007]

According to Credit Suisse:

http://personal.crocodoc.com/waAog87

The Money Market Under Government Control

The Fed’s new Reverse Repo (RRP) facility could get big – very big – as interest rates start to rise, despite what Fed officials have been saying. The facility has been trending around $150bn, roughly 1/20th of the level of bank reserves.

A much larger RRP facility – think north of a trillion – would represent the endpoint of an evolution that began before the crisis, when large dealer repo books stood between institutional cash pools and leveraged carry trade investors to…

after the crisis, when bank balance sheets were expanded by both reserve assets and deposit liabilities created by QE to…

the future, when government-only money funds grow to hold large volumes of RRPs as assets and issue fixed-NAV shares (money) to institutional cash pools.

What are institutional cash pools? Think corporate treasuries and the cash desks of asset managers and FX reserve managers. Their demand for short-term, money-like assets has had a strong secular growth for several decades.

New regulations have constrained some investors in terms of what they can buy, and many institutions, in terms of what they can (profitably) issue.

History shows that when financial innovation occurs or rules change, the least constrained players grow.

In contrast to banks and dealers that face various charges on capital and balance sheet, and prime funds whose shares have lost “moneyness” due to regulation, government funds are relatively unconstrained.

They will likely grow, fed by an RRP facility that may grow much larger and become a permanent fixture of the financial system. In our view, this would herald the arrival of an era of financial “RRPression” in the US money market where the sovereign dominates and dealers play a supporting role – the inverse of the pre-crisis state of affairs.

While this shift would undoubtedly reap massive financial stability benefits, the main reason why the RRP facility might need to get much bigger is not financial stability related, but rather revolves around the Fed’s potential inability to control short-term interest rates in an era where Basel III and banks satiated with excess reserves hinder monetary transmission.

Why pay attention to this plumbing stuff?

Because the infrastructure of markets determines which trades can profitably be done, and which institutions will grow in importance over time.

This piece marks a return to our prior focus on shadow banking and the global financial system (see references at the end).