Treasury market liquidity has been talked about as a potential risk factor for at least the last couple of years; and it may be worsening. At least that’s according to Bloomberg’s US Government Securities Liquidity Index. 

This measures the dispersion of prices from an imaginary smoothed yield curve.  

While dispersion does not measure liquidity directly, it reflects the amount of arbitrage capital in the market and serves as a proxy for liquidity.  

The ‘noise’ this measure shows has got louder this year. The higher the number, the less liquid the market – it recently hit 5 and although it has since come down sharply, remains elevated – staying well above the peak hit during the Covid liquidity squeeze. 

Chart source: Bloomberg 

Should we worry?  

Not in the slightest says Michael Fleming, the head of Capital Markets Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.   

He notes that it remains far below its peak during the great financial crisis (GFC). “Moreover, it remained far below its GFC peak in March 2020 even when direct liquidity measures approached GFC levels and the Fed unleashed massive asset purchases to address the dysfunction then roiling the market (described in this paper). “ 

Some suggest that the Bloomberg index reflects fragility rather than illiquidity. And, fragility concerns meant we talked a few months back about concerns about positioning in the Treasury market.  

But the NY Fed’s periodic assessment of Treasury market liquidity, which Fleming authors, suggests things have improved this year. 

“Standard metrics point to an improvement in Treasury market liquidity in 2024 to levels last seen before the start of the current monetary policy tightening cycle. Volatility has also trended down, consistent with the improved liquidity,” writes Fleming. 

The $27tn Treasury market is the largest and most liquid government securities market in the world.  

Market liquidity can be defined as the cost of quickly converting an asset into cash (or vice versa) and is measured in various ways. As in the past, Fleming looks at three common metrics to gauge liquidity: the bid-ask spread, order book depth, and price impact. 

In 2022 and 2023 the NY Fed raised concerns about the negative relationship between volatility and liquidity.  

But things have settled down since the Fed warned on low liquidity in a number of assets, including the Treasury market, two years ago. Improved liquidity has gone hand in glove with lower volatility, which could be down in part at least to expectations that the Fed would be cutting rates; the asymmetric impact of hiking (more uncertainty and therefore higher volatility) vs easing cycles. 

Bid-Ask Spreads Remain Narrow 

Bid-ask spreads widened during the Covid-related disruptions of March 2020 and again around the banking failures of March 2023. However, both times these narrowed quickly and remained “narrow and stable” since mid-2023. 

Source: Author’s calculations, based on data from BrokerTec.

Notes: The chart plots five-day moving averages of average daily bid-ask spreads for the on-the-run two-, five-, and ten-year notes in the interdealer market from September 1, 2019 to August 31, 2024. Spreads are measured in 32nds of a point, where a point equals one percent of par.  

Order Book Depth Is Increasing 

Here is Fleming: “The next chart plots order book depth, measured as the average quantity of securities available for sale or purchase at the best bid and offer prices. Lower depth implies worse liquidity. Depth plunged in March 2020, recovered thereafter, and then declined again in the months around the start of the current policy rate tightening cycle in March 2022 and around the banking failures in March 2023. Depth has generally been rising since March 2023, hitting levels comparable to those of early 2022, but declined temporarily in early August 2024 around a weaker-than-expected employment report and global equity market declines.” 

Source: Author’s calculations, based on data from BrokerTec.

Notes: The chart plots five-day moving averages of average daily depth for the on-the-run two-, five-, and ten-year notes in the interdealer market from September 1, 2019 to August 31, 2024. Data are for order book depth at the inside tier, averaged across the bid and offer sides. Depth is measured in millions of U.S. dollars par and plotted on a logarithmic scale.  

Price Impact Is Declining 

“Measures of the price impact of trades also suggest an improvement in liquidity,” writes Fleming.  

The chart below plots the estimated price impact per $100 million in net order flow. A higher price impact indicates worse liquidity.  

We can see price impact rising sharply in March 2020 as the pandemic hit and rising again in the months preceding and following the start of the current tightening cycle. From the chart price impact does not suggest liquidity problems for now. 

Source: Author’s calculations, based on data from BrokerTec.

Notes: The chart plots five-day moving averages of slope coefficients from daily regressions of one-minute price changes on one-minute net order flow (buyer-initiated trading volume less seller-initiated trading volume) for the on-the-run two-, five-, and ten-year notes in the interdealer market from September 1, 2019 to August 31, 2024. Price impact is measured in 32nds of a point per $100 million, where a point equals one percent of par. 

But even if liquidity is improving – beyond the Bloomberg measure that is, fragility is arguably becoming more pronounced. That may be because dealers are using balance sheet to trade. 

Barclays was out with a warning earlier this year.  

They said: “We expect important parts of the fixed income market to suffer from increased fragility over the next several years. This is really the continuation of a trend, evidenced by two high-profile recent disruptions: the 2019 repo market volatility and the COVID-induced ‘dash for cash’. In fact, the nature of shocks has been worsening since 2016, with both more frequent and more severe disruptions in Treasury and funding markets.” 

Improved liquidity does not necessarily equate to a less fragile market.  

Neil Wilson

Chief Market Analyst at Finalto

All opinions, news, research, analysis, prices or other information is provided as general market commentary and not as investment advice and all potential results discussed are not guaranteed to be achieved. The information may have been derived from publicly available sources, company reports, personal research, or surveys. Past performance is not indicative of future performance. Trading carries risk of capital loss. Service available to professional clients only.