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One of the more worrying aspects of the sell-off in the US Treasury market is the relative paucity of actual selling.
While the 10-year Treasury yield has risen from below 1.9 per cent in mid-April to a peak of almost 2.5 per cent this week, traders say the increase has been driven by lower amounts of trading than the steepness of the climb would suggest.
Investors, bankers and analysts have in recent years been worrying over the deteriorating trading conditions in corporate bond markets, but increasingly some are fretting that the liquidity of the biggest and most actively traded market of them all — US Treasuries — should be the biggest concern.
“It’s definitely not functioning as normal,” notes Jack Flaherty, a New York-based bond fund manager at GAM.
Deutsche Bank’s strategists have estimated that the average turnover in investment-grade and high-yield bond markets has declined 50 per cent and 30 per cent respectively from peaks in 2006-07. But the German bank’s measure of Treasury liquidity — the average proportion of the market that changes hands on a daily basis — had slumped 70 per cent since its noughties peak.
“The focus on liquidity is correct, but people are looking in the wrong place,” says Oleg Melentyev, one of the note’s authors. “High-yield investors are very aware of the illiquidity in their market, but people are less aware of the problem in Treasuries. So that’s probably where we’ll see the bad surprises.”
The US government bond market remains vastly more liquid than its counterparts. Using Deutsche Bank’s measure of liquidity it is about 10 times more actively traded than investment-grade corporate debt.
In fact by some measures the Treasury market looks in rude health. Despite the rise in yields, the US government’s benchmark borrowing costs remain at levels that would have been unimaginable a few years ago.
Moreover in absolute terms daily trading volumes are robust at about $500bn a day, and the difference between the price at which investors are willing to buy or sell Treasuries — a widely watched gauge of liquidity — has shrunk down to pre-crisis lows.
These measures of liquidity, however, do not necessarily reflect the diminishment in the market’s “depth”, or the ability of investors to trade big chunks of Treasuries easily without unduly moving the price.
To measure this JPMorgan’s bond strategy team took the top three bids and offers in “on-the-run” (newly issued) Treasuries in the early morning, when trading is more active. They found that depth deteriorated severely during the financial crisis, and occasionally at times of stress since, but has averaged about $171m for 10-year Treasuries over the past eight years. This year the depth has averaged only $116m.
Franklin Templeton has not experienced any significant problems trading US government debt, according to Mike Materasso, head of Treasuries at the asset manager. “But that doesn’t mean we shouldn’t be worried,” he says. “The stats paint a potentially bleak picture.”
The decline in Treasury liquidity has many causes. Although the size of the market has swollen since the financial crisis, much of the extra issuance has been absorbed by the Federal Reserve’s quantitative easing programme, or snapped up by foreign central banks keen to bolster currency reserves. That leaves less for actual trading.
At the same time the footprint and influence of big banks known as the primary dealers have faded. Commercial and regulatory pressures have forced them to trim involvement in the Treasury market. That hamstrings their ability to act as shock-absorbers in turbulent times — as became clear when the Treasury market careened up and down last October.
The turmoil was brief but so severe that some banks were forced to shut their automated electronic trading systems. “When you have moves like this you’re just hanging on for dear life,” says one senior trader.
The holdings of the Fed and big overseas investors also have a knock-on effect on the “repo market”, which greases the global financial system by allowing investors to trade safe collateral — such as Treasuries — for short-term funding. Stricter regulation has gummed up the repo market, and in turn weighed on the liquidity of the underlying securities.
While US Treasuries remain a cornerstone of the global financial system, as the default risk-free assets of choice, one of their main advantages is liquidity. If that is falling then investors might demand slightly higher yields as compensation.
JPMorgan has nudged up its year-end forecast for the 10-year yield from 2.40 per cent to 2.55 per cent, despite no change to its economic views.
“Over the past few years, many market participants have come to fear this [lack of liquidity] of corporate bonds, and this is probably one reason why corporate spreads have remained stubbornly wide,” wrote Jan Loeys, head of global asset allocation, in a note. “Now the fear and reality have spread to what were before considered the most liquid bonds in the world.”
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