Over the past several months we’ve spent quite a bit of time discussing liquidity (or, more appropriately, a lack thereof) in the market for US Treasurys, German Bunds, and JGBs.
Liquidity in government bond markets has become a hot-button issue in the wake of last October’s Treasury flash crash wherein the world’s deepest, most liquid market was suddenly exposed as having become nothing more than a playground for the Fed and HFTs. Six months later, the market was again forced to bear witness when German Bunds, the safe haven asset par excellence, began to trade like a penny stock as the reincarnation of 2013’s JGB VaR shock sent 10-year Bund yields on a wild ride from just 5 bps to nearly 80 bps in the space of just three weeks (the rout resumed last week, with yields rising above 1% on Wednesday).
The great Bund battering provided an opportune time for analysts to revisit the idea of illiquid government bond markets, and invariably, the focus turned to Treasurys and Bunds. Here’s what JP Morgan had to say recently about market depth for US Treasurys:
Market depth for USTs is proxied by the 5-day average of tightest three bids and asks each day, shown in Figure 7 in $mn for 10y US Treasuries. Similar to US IG corporate bonds, there was an earlier collapse in market depth during 2007 already as the US subprime crisis erupted. But different to US IG corporate bonds, there has been a deterioration in UST market depth in the most recent years, since 2013. We argued before that the deterioration in UST market depth since 2013 reflects the contraction of US repo markets caused by regulations as well as UST collateral shortage induced by the Federal Reserve’s QE3 program coupled with a declining US government deficit. A retrenchment in repo markets is unwelcome news for the liquidity of the underlying securities. Most repos, around 80%-90%, are against government-related collateral and it is the repo market which makes government securities relatively more liquid by allowing fast and efficient financing and short covering. It is not accidental that trading volumes in bond markets are so closely related to the outstanding amount of repos. See previous Flows & Liquidity “Leverage ratios to hit repo markets”, July 19th 2013 which shows that US outstanding repo amounts and overall bond trading volumes have been drifting lower in recent years with no signs of a return to pre Lehman levels. And similar to USTs, Bund and JGB market depth has been also suffering as a result of government collateral shortage inflicted by the ECB’s and BoJ’s QE programs and shrinkage in their respective repo markets.
Now, UBS is out with a fresh take on UST market liquidity. Investors, UBS says, are increasingly turning to futures as liquidity in the cash market dries up. Here’s more:
Bond market liquidity has become such an overriding concern for investors that mentioning "liquidity" in the title could simply be a plot to entice readers.
Markets for high-quality government bonds can get out of balance due to rising one-sided demand to transfer risk. Consequently, market-makers' have a limited ability to serve as "shock observers." At this point, we need to consider the true meaning of liquidity. Is liquidity the ability to execute fairly small trade at tight bid-ask spreads, or being able to get a price – any price – for a truly large transaction? In our opinion, the latter form of "liquidity" is the important one.
At the same time that one investor has difficulty doing a very large trade at a tolerable level, a multitude of smaller trades could be executed at or near mid-market. Furthermore, algorithm-driven trades also likely would happen close to mid, even while the market is gapping, since algos would simply not execute if bid-offer were too wide. In this case, publicly reported bid-offers in Treasuries may move very little, yet liquidity has fallen in the most meaningful sense.
Futures provide clues
We turn to futures to help us discern liquidity trends. First, consider US Treasuries. A relative shift in turnover volume from cash bonds to futures could arguably serve to confirm worsening liquidity in cash Treasuries. Futures mechanics help mitigate both the balance sheet constraints and the potential challenges of flow trading restrictions, since participants need to fund only a small portion of notional and they always effectively transact with the exchange.
Figure 12 plots turnover volumes of the entire futures and cash Treasury markets, and their ratio (dark line, right axis). It reveals an unambiguous trend: turnover in futures has been catching up to cash Treasuries. To be clear, we compare total market volumes by simple par amount.
For the past three months, daily average futures volume stands at nearly 70% of cash Treasuries, based on the notional amounts transacted. That is up from about 50% in 2011. The big leap in the turnover ratio occurred in 2014, and appears to have been sustained this year.
Figure 13 and Figure 15 shows a stark shift in the way market participants access liquidity in short and intermediate Treasuries. The futures/cash turnover ratio surged in 2014 from the low 20s to 40% for short maturities and from low 40s to 60% for intermediates.
Migrating to futures from cash bonds may introduce a new set of challenges to investors. First, running large structural futures exposure in place of cash bonds does increase counterparty risk. Instead of having direct custody of full faith and credit government bonds, investors face a clearinghouse when they hold futures. True, major clearinghouses have excellent track records in getting past various crises. Still, regulators and policymakers have expressed concerns about potential systemic risk of central clearing counterparties.
Note that this is still more evidence of the market-wide shift out of cash and into derivatives in order to avoid illiquidity. This is the same dynamic that's causing fund managers to use ETFs to avoid tapping illiquid corporate credit markets (see here and here) and serves to reinforce what we said back in February when we highlighted a Citi client survey which showed that increasingly, sophisticated investors are turning to derivatives not for hedging, but to express directional views on markets:
Fair warning: the more often derivatives are used as a way of avoiding the underlying cash markets, the more illiquid those cash markets become, meaning the 'solution' to illiquidity effectively makes the problem orders of magnitude worse.