On October 15, the deepest and most liquid market in the world demonstrated a six standard deviation move in less than two hours, a move that happens once in 506,797,346 days! It is impossible to suggest that this supersized move in the US Treasury market was due to downward assessment of economic expectations. Economic expectations shift weekly – if not daily. Clearly, a shift in the structure of the US Treasury market and substantial reduction of private sector market makers is at the core of recent complications. Similarly, this issue extends well beyond simply the sovereign debt market for US securities, as a result of the interconnectedness among markets and the unique role for Treasury debt as benchmark securities. To be sure, a sustained “flash crash” in the world’s leading fixed income market could readily unleash a pronounced slowdown of the global economy, or worse.
The amount of U.S. debt available to trade at one time without moving prices as of October has plunged 48 percent to $150 million since April, according to JPMorgan Chase & Co.
...the reduction of market finance is excessively steep. The CFS measure of market finance is down a stunning 46% in real terms since its peak in March 2008! This phenomenon starves financial markets from needed liquidity and is detrimental to future growth by exposing the economy to potentially unnecessary shocks.
A Deutsche Bank index that gauges liquidity by the three-month average size of daily dealer transactions in Treasuries relative to the variability of the 10-year note yield during that period is down to a reading of about 25, from over 500 in 2005. The current level is close to the low of about 19 at the depth of the financial crisis in 2009.
...a recent report by BlackRock highlights how “the secondary trading environment for corporate bonds today is broken.” Data suggest that diminished corporate bond liquidity is in part due to limited participation by market makers. For example, debt holdings by primary dealers are down by 80 percent since a peak in October 2013. These examples signal that the probability of an accident is high and the stage is set for an adverse event meeting with an outsized impact on markets and possibly economies.
We predicted this 18 months ago, when we warned that “the slightest gust of wind, or rather volatility, threatens to shut down the secondary corporate bond market, which already is running on fumes.”
Of course the last thing you would want to see in this type of environment is a scenario wherein non-human actors are all programmed to move in exactly the same direction at exactly the same time, thus exacerbating the already amplified (thanks to the illiquidity issue) impact of a market-moving event. Thanks to the rise of the machines (a fifth of electronically executed Treasury trades will be executed by robots this year), we have precisely that, as even the zen masters at Bridgewater are starting an artificial intelligence unit. As we noted previously, “it seems that everyone has forgotten [what happens] when all the machines chase down the same rabbit holes?”