Guest Post: Treasury Bears And Extinction Events

Submitted by JM

Treasury Bears and Extinction Events

The real meaning of a treasury bear market may not be a flight out of treasuries into another asset class. Rather it real import could be the lack of liquidity available anywhere for nearly any asset class.

History seldom repeats precisely, but it does rhyme as they say.  And there are different types of bear markets:  bear steepening and bear flattening. Despite the complications, history and imagination are our only guides.

Bear Market in Treasuries

First for some rough context, monthly yield curves for the 1977-1982 Bear market are shown against the yields curves of January 1977 and December 1986 (in red).  What you see is a massive sell-off across the curve combined with flattening and inversion of the short end.

See the close up below for something more digestible.  There was serious volatility, mostly at the wings.  Yields on the 1Y exploded from 8.16% in June 1980 to 16.52% in September 1981.  Yields on the 30Y moved from 9.17% in August 1979 to 14.68% in September 1981. 



This section is premised on ample liquidity.  It is all I’ve ever known in Treasuries, but it may not be appropriate.  

  • Roll-down wasn’t possible at the mid-curve, but it was possible to get roll-down on the front end.  It was a high-risk play, because the volatility was amazing and would rip your face off.  In just a couple of months, the whole curve could invert on you.
  • You could make money shorting 20s30s, but I can’t imagine anybody doing that more than as a punt.  I don’t know if traders then bought or sold things like a 10s20s30s butterfly.
  • A major point is that you really had to stick your neck out to make money in Treasuries.  The “old” adage now is nobody ever got fired for buying treasuries—although it isn’t quite true.  Seems that there was likely an even older adage about treasuries and how awful they were. 

Presumptions of Liquidity

Liquidity acts in a financial system like ample water, ambient temperature, and clean air act in an ecosystem.  It makes trading strategies proliferate.  Further, it makes meaningful intermediation possible, fostering the growth in high yield bonds and marketable loans.  Yes, derivatives like vanilla stock options and others too.

A financial system without liquidity is like a tropical ecosystem dried into a desert.  Without liquidity, it is an open question whether the arbitrage pricing revolution will outlast the antiquated mark-ups of reinsurers.  Liquidity makes random processes stationary, which is crucial to make the probabilistic foundations of risk neutral pricing work.  Is it intuitively possible to price (and even more buy and sell) credit and interest rate risk without some liquidity in the underlying?  How can a bank generate carry when the curve is flat and there is no appreciable differential anywhere that has a minimum tolerance of liquidity?

I put together an impressionistic schema to convey my point about liquidity.  It not only demonstrates instruments stop functioning, but even wholesale trading strategies have to be abandoned.  Traders will not only have a limited palette of instruments; for survival, they will also have to simplify trading strategies to those that are proven across extremely wide environments.  In financial markets, liquidity is what makes innovation possible.  Innovation adds complexity and diversity to an ecosystem, but it doesn’t make the system robust.  Even miniscule changes in environment cause life to revert back to sparsely populated rhythms.