"Where have all the players gone ..... ?" (with apologies to Peter, Paul and Mary)

Friday 12th June 2015

"Where have all the players gone .....  ?"  (with apologies to Peter, Paul and Mary)

 "Treasury volumes raise liquidity concerns" , The Financial Times, p.32

Regular readers would be forgiven for thinking that the problem of illiquidity in bond markets (and others) has become something of a "bugbear" issue for this blog. Not only would they be forgiven, they'd be right. The only defence is that it's a matter of deep concern to much greater and more important minds than this one.

Whilst the German Bund market has become increasingly influential on a global stage and attained benchmark status in its own right, we should take a look at by far the biggest market of them all, US Treasuries. Deutsche Bank's measure of Treasury liquidity  --  the average proportion of the market that changes hands on a daily basis  --  has fallen by 70% from its peaks in 2005/6. Traders make the point that the market is "definitely not functioning as normal"..... perhaps we should add "or what used to be taken as normal". The point is also made that whilst illiquidity and its attendant problems have long been acknowledged as part-and-parcel of trading riskier high-yield assets, this is a new and most unwelcome phenomenon for Treasuries.

At first glance, some measures of the market's health look reasonable enough. Though a long way off its highs, daily volume of $500bn should be enough for a functioning market. Moreover, the average spread between bids and offers is as low as it's been since the financial crisis. But the problem comes when you assess how much business you can actually get done in current conditions. By JP Morgan's reckoning, on average since the crisis and at times of peak activity, if you had a large sell-order for 10yr Treasuries and hit the first three bids, you would been able to get away $171m. Now, the figure would be just $116, and the contrast with pre-crisis equivalent is much starker.

The causes ? Ironically, the size of the market as a whole has actually grown but much of the new bond issuance has been absorbed by the Fed's Quantitative Easing programme and other central bank purchases and thus, from a trading point of view, is removed from circulation. Perhaps most importantly, the banks who acted as primary dealers have to a large extent withdrawn from the market-place. In the risk-averse,post-crisis era such a role is viewed as inappropriate and new regulation makes it too expensive and too difficult to operate even if they had the will to do so. In effect, one of the market's main shock-absorbers has been removed.

It's not easy to see a solution to the issue . The problems of illiquidity, volatility and consequent costs of trading, look here to stay. So much so in fact that investors may demand some kind of illiquidity premium. JP Morgan has pushed up its year-end forecast for the 10yr Treasury yield from 2.40% to 2.55%, even though it has changed its economic views not one jot.