Thursday, April 23, 2020

Treasury Liquidity

So just what was the "disruption" in the Treasury market that so spooked the Fed, that now the Fed is buying more than the Treasury is selling?

A commenter on my last post on corporate bonds points to Treasury Market Liquidity during the COVID-19 Crisis by Michael Fleming and Francisco Ruela at the NY Fed, April 17 .

Michael and Francisco nicely show us the facts. They make no editorial comment at all, except perhaps in the figure titles, so my questions about just how big a problem this is are not directed at them.

Bid-ask spreads widened, to financial crisis levels (when the Fed did not, by the way, intervene.) The plot is hard to read in the far right end in order to compare to 2008. (Suggestion to the authors: focus on the last three months so we can see what was happening, not on the comparison to 2008.) As far as I can make it out, the 5 year spread widened form 0.25 /32 to about 0.4 /32; the 10 year from 0.5 to 1.0 and the 30-year from 1 to 5.

If I read the caption correctly, each of these numbers is 1/32 of one percent of par, 0.03%, so the 5 year spread went from 0.008% to 0.012% and even the 30 year went from 0.03% to 0.16%.

The "order book depth, measured as the average quantity of securities available for sale or purchase at the best bid and offer prices" (my emphasis) declined. There is usually a lot more for sale if you're willing to pay more.

The difficulty of trading includes not just the bid ask spread, but a guesstimate of how much you will depress prices if you sell $100 million in a huge hurry. This price impact went up. But, it is measured as "slope coefficients from ...regressions of one-minute price changes on one-minute net order flow." How bad is it to wait a whole minute to sell $100 million? Also, most traders use fairly complex strategies to minimize price impact. And there is lots to complain about in this measure of price impact. (I prefer autocorrelation measures -- how much did the price bounce back.)

And the absolute value looks to a layperson remarkably small. 7/32 = 0.22%, two tenths of a percent, on the 5 year bond. OK, 0.75% on a 30 year bond which is almost real money. But 30 year bonds are pretty volatile anyway as we'll see in a moment.

Price volatility jumped, especially (actually almost entirely)  for the 30 year bond. The 30 year bond was experiencing 70% annualized volatility, which is 4.4% per day. That puts some of these spread and price impact measures into context. They are orders of magnitude smaller than the daily price volatility.

This is not unique to the Treasury market.  Stock price volatility went through the roof too by the way. Here's the VIX, peaking at 80. The Fed has not yet seen fit to buy stocks, and let us hope it does not do so.

Throughout all these numbers, the steady march from 1, 5, 10, to 30 year bonds is instructive. Longer bonds are more volatile always. "Liquidity" is usually confined to the shorter maturities.

Trading volume was high too. Again you have to squint to see it.
... daily trading volume in the market overall reached a record high for the week ending March 4, averaging over $1 trillion, roughly twice its post-crisis average
What does it all add up to? 

A trillion dollars a week is a lot of buying and selling. What's "disruptive" or dysfunctional about that? This isn't Costco, whose trading volume in toilet paper went to zero after it sold out.

To me, there is a sense of utterly normal in all of this. Supply curves slope up, of everything, including "liquidity."

Obviously, we hit a period of huge uncertainty, divergence of opinion, and liquidity needs. The fundamental, rational, normal, functional, whatever you want to call it, price will be quite volatile, as was the stock price. The fundamental, rational, normal, whatever you want to call it desire to trade will rise as well.

So how does a market react when there is a large increase in the volatility of prices and demand for trading. Well, supply curves slope up -- that demand is accommodated but at a higher price.

Dealers who buy and have to hold securities in inventory for a day or two are more exposed to risk when prices are more volatile, so they buy less other things constant. Bid ask spreads and price impact rise to give them a higher profit, commensurate with that risk. In a time of volatility, there is more asymmetric information, so dealers charge a higher bid-ask spread. This may sound like less of a problem for Treasuries, but there is short term information about future order flows and future Federal reserve actions and even interest rates given the huge macro uncertainty. And the price volatility may be both a sign of trading demand and an inducement to it. If you can spot the direction, there is a lot more money to be made.

Supply and demand. If trading volume goes up while spreads and price impact are rising, the shock is to the demand for trading. If trading volume went down while spreads and price impact rose, the shock is to the supply of trading services. This event sure looks like a shock to demand, accommodated pretty well by dealers. (I wrote a paper a long time ago called "stocks as money," documenting a similar case of demand for trading)

Where is the evidence that something is wrong with supply, that there is also a shift in the supply curve?

Michael and Francisco wryly note the same point:

High trading volume amid high illiquidity is common in the Treasury market, and was also observed during the market turmoil around the near-failure of Long-Term Capital Management (see this paper) and during the 2007-09 financial crisis (see this paper). Periods of high uncertainty are associated with high volatility and illiquidity but also high trading demand. 
Not surprisingly, volatility caused market makers to widen their bid-ask spreads and post less depth at any given price, and the price impact of trades to increase, illustrating the well-known relationship between volatility and liquidity. 
So just where is the fire here? Where is the screaming hole in financial markets that justifies the Fed buying $1.3 trillion treasury securities in a month?

Even if "intermediation" were the problem, why is buying up the whole supply the answer, not both buying and selling, to reduce bid-ask spreads?

The Fed announced:
To support the smooth functioning of markets for Treasury securities and agency mortgage-backed securities that are central to the flow of credit to households and businesses, over coming months the Committee will increase its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion.
How does buying it all up promote the "smooth functioning" of markets?  Is there anything more than
"because of (big financial gobbledygook which you wouldn't understand anyway so it doesn't matter if it makes any sense) we're going to buy a trillion dollars of treasurys?"

Finally, if absolute liquidity in Treasury markets is so important, if the ability to transact at 0.01% or less loss, in minutes, is a crucial social problem, then why not talk about some fundamental reforms to those markets?
As described in this post, roughly half of Treasury securities trading occurs through interdealer brokers (IDBs), in which dealers and other professional traders transact with one another, and roughly half between dealers and clients. Our focus is on the IDB market, and on the electronic IDB market in particular, which accounts for about 87 percent of IDB trading. 
Wider trading would make a lot of sense. Federal debt is carved up into 250 different securities or more. As I argued here, if you want them liquid, rearranging federal debt to only a few securities would make each one more liquid. If "balance sheet space," i.e. inadequate equity financing and regulatory risk-taking constraints, are stopping those with expertise in market making from making more markets, why in heaven's name after 12 years of Dodd-Frank act, capital requirements, essays on equity-financed banking, Volker rule and the rest, don't broker dealers have enough equity capital to let them trade through the covid-19 virus on top of a new cholera pandemic and a war? "Constrained balance sheets" are not a fact of nature, they are the product of 12 years of regulatory failure.

 There is a tendency throughout economics to write, "here is my policy," then "here are the problems that motivate my policy." But if you look at the problems, a lot of other policies would solve them better. Economics is too often answers in search of questions.

So, bottom line, I'm still looking for evidence. I'm willing to give the Fed the benefit of the doubt. All the people I know at the Fed are smart and well-intentioned looking at a lot more data than I am. Just what is it that motivates buying a trillion dollars of treasury debt, and more trillions to come?


  1. John, putting aside the functioning of the treasury market entirely, don't you think it is appropriate for the Fed to be easing right now? Don't you think that it's likely that the Fed is simply trying to ease, and then come up with what they think is a politically correct justification for that easing after the fact? My perception is that the Fed knows that its not necessary to purchase treasuries to facilitate the functioning of the treasury market, they just think saying that is the best way to minimize political backlash.

    I don't support the Fed's apparent policy of misleading the public when it comes to their reasons for easing, and in fact I think it reduces the effectiveness of that easing by distorting expectations of future fed policy. But I do support the Fed's decision to ease at a time where inflation and nominal growth expectations have cratered, and so am willing to cut them a bit of slack on the way they justify that policy.

  2. Thank you one million times!!!! Can we please stop producing mindless charts with a spike and then conclude that this somehow demands Fed intervention. Please?!!

    Look at the units on the y-axis for heavens sake - it is in 32nds of a point! With a powerful enough microscope on market activity you can substantiate any intervention whatsoever!! And as you point out, risk is up so spreads are up - dealers don't intermediate as a charity.

  3. "Just what is it that motivates buying a trillion dollars Treasury debt, and more trillions to come?"

    Answer: Double-entry book-keeping.

  4. The US government is issuing a lot of Bonds to finance deficit spending and so the FED is buying US government bonds to reduce the "crowding out" effect on private sector funding due to an abundance of government bonds.

  5. "So how does a market react when there is a large increase in the volatility of prices and demand for trading. Well, supply curves slope up -- that demand is accommodated but at a higher price." The S&P 500 ETF, SPY, declined 33% from the 2020 high of 338 to 222. The Fed did not step in.Buyers bought all the way down and some traders were hedged. (The benefit of derivatives). An orderly market decline that took about a month. The VIX at 80 was and has been a good buy signal when dealing with time varying risk.The market has recovered almost half its loss with VIX reverting to its mean. Again, there is liquidity and order but always at a risk adjusted price.

    1. You cannot disassociate movements in the S&P / VIX from Fed actions. Liquidity provision, as the Fed was doing, is volatility selling. By selling vol in massive scale, the Fed put a cap on the rise in the VIX and led to it's (partial) reversion. This directly lowers the equity premium, which is why you had a rally in S&P 500.

    2. I agree. The Fed's actions lowered interest rates. The result a search for yield in risky assets. The result, a rally that lowered equity premia. What happens when the FED unwinds its balance sheet? Being a former CBOE market-maker, AMEX specialist and fund manager, I will always buy puts to hedge. I may give up some upside but when the VIX is at 80, I won't care.

  6. Maybe the Fed is just doing what markets expected it would do. I guess bid-ask spreads in the treasury markets could have been "problematic" otherwise.

  7. Real reason seems more likely what was going on with closed bond funds vs prices. See the chart here

    Like you, I don't a good sense for why small shifts in conventional liquidity measures should translate to large price dislocations. I suspect the real liquidity issue wasn't with primary dealers but instead too many people at the same time thinking they were holding the wrong assets for what lies ahead. i.e., a run.

  8. The answer is low bond prices.

    The nominal T-bonds and TIPS yields spiked up around March 19. This would be the wrong time for government yields to rise because corporations were looking to issue bonds. BBB spreads peaked March 23. The Reuters headline of April 2 says high grade issuance set a weekly record.

  9. this is a really interesting posting. i've studied the topic of treasuries liquidity and trading in some depth and have a few comments / questions

    1. is there any information on what happened to spread and order book depth AFTER the fed action? if bid-ask spreads were widening because dealers saw this as an opportunity to price buyers of treasuries at a higher price point, wouldn't the additional demand created by the fed exacerbate the problem rather than solve it? looking at detailed time series of bid and ask volume around this time period could shed some interesting insights. this is (or was) available for purchase for espeed (second biggest treasuries electronic platform), but not brokertec (biggest) and can be run quickly with some good coding

    2. has anyone looked into what the behavior of high frequency tradings shops were during this time? they make up a surprisingly large share of the treasuries trading volume. one possibility: they pulled the plug on some of the algo trading, leading to a drop in volume and an increase in the bid-ask spread

    3. on your main point of "why is this such a big deal?", in and of itself, it doesn't appear to be a major systemic risk to the market. but perhaps this, the disruption in the bond market, the rapid drop in equity prices, and other indicators (which were probably built mostly off of what happened during the previous financial crisis) were all blinking red and it spooked the fed into taking action

    4. it's easy to criticize the fed ex post, but from their perspective and without the benefit of hindsight, the market for world's most liquid and highly traded asset was going haywire and they had to do something to stabilize it

    5. one final somewhat tangential point.. the simple supply-demand framework applied to spreads (price) and volume (quantity) is too simplistic. there could be a scenario where the market making function is disrupted significantly, but volumes are high because buyers keep crossing to the next highest ask (or vice versa on the sell side)

    1. Regarding (5), I think that is precisely the point John was trying to make. If volumes are high (demand for liquidity up), that means lots of traders are crossing the spread, which should result in a larger spread (price up), even if the market making function (supply) is unaffected.

  10. As always very interesting post. However, there is one point that demands some reflection. You write:' Supply and demand. If trading volume goes up while spreads and price impact are rising, the shock is to the demand for trading. If trading volume went down while spreads and price impact rose, the shock is to the supply of trading services. This event sure looks like a shock to demand, accommodated pretty well by dealers.' However, the graph shows DOLLAR trading volume, which is not the best measure to evaluate trading volume because it does not take in consideration the supply of the financial instrument. To keep this in consideration you should use TURNOVER (Traded securities/Number of securities available on the market). Considering that the Treasury needs to issue a lot of new securities, the denominator is expected to go up, hence TURNOVER is expected to go down.

  11. This article says that there was a trillion dollars invested in a leveraged strategy that was failing when stocks prices and bond prices were going down simultaneously. The 10 year T-bond price decreased starting on March 9. The leverage leads to margin calls or forced liquidation.


    Stick to Asset Pricing and Macro-Finance.

  13. "Market disruption" means prices that someone the New York Fed has talked to doesn't like. Same thing with market "dysfunction" and "illiquidity."


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