Currencies may be considered the most liquid of all quoted markets, but the most liquid market that most investors think about day in and day out is the U.S. Treasury capital market for bonds. This market governs the direction of U.S. interest rates, and international interest rates in many cases, each day of the week. So what happens under new regulations when there is now a liquidity gap in the US Treasury market among the regulated primary dealers?

This issue has been brought up by Jamie Dimon of J.P. Morgan, and was later said to be an issue by former Treasury Secretary Larry Summers. The point made was that regulators should make a priority of addressing the problems of bond market liquidity. It was the regulation around “trading activities” which created what is perhaps unintended consequences.

24/7 Wall St. has spoken with an executive of another top firm, which is a primary dealer, and his firm just recently had internal discussions about how their firm used to be able to handle $100 million in Treasury bids at any time without any issues – and now that figure was a small fraction of that.

Much of the risk in liquidity has been tied to the Volcker Rule and under other aspects of Dodd-Frank. Getting formal figures is very difficult to do, particularly since many bankers and traders do not want to run against regulators. Right now, most bankers and traders at regulated financial institutions are operating under the assumption that regulators still get to be right even if they are proven wrong.

The current climate has not seen any catastrophic outcome from the lower liquidity in the bond market. Now consider a time of serious selling into the coming interest rate hike cycle which some investors worry about. Or imagine if the Federal Reserve ever needed to dump even a relatively decent portion of its $2.4 trillion or so in Treasury securities.

The Federal Reserve is attempting to study and assess these liquidity concerns. Obviously the regulatory climate in the aftermath of the great recession meant to take out the risk that these financial institutions play in the public.

At the end of the day someone or a group of some firms have to be able to trade all the paper that has been created. And it is the government which has created the most of it — Treasury Direct shows that there is currently $13 trillion in direct debt held by the public, plus another $5 trillion in intragovernmental holdings via agency issuance and the like.

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On Wednesday a Federal Reserve report was noted in a Fed speech on this matter. The speech came from Governor Lael Brainard at the Salzburg Global Forum on Finance in a Changing World. Brainard’s speech said:

Recent events and commentary raise concerns about a possible deterioration in liquidity at times of market stress, particularly in fixed income markets. These concerns are highlighted by several episodes of unusually large intraday price movements that are difficult to ascribe to any particular news event, which suggest a deterioration in the resilience of market liquidity. For example, on the morning of October 15, 2014, 10-year U.S. Treasury yields gyrated wildly, and the intraday movement in Treasury prices was 6 standard deviations above the mean. In addition, after 4 p.m. on March 18 EDT of this year, a meeting day for the Federal Open Market Committee, the U.S. dollar depreciated against the euro by 1.75 percent in less than three minutes, an unusually large drop in such a short interval. A few weeks later, markets experienced some very large intraday movements in the price of German bunds during times of little market news.

While some market volatility has been attributed to strong moves, it was said to be evidence of some deterioration in the resilience of liquidity. Several risks were brought up here. One was during times of stress, one was if it acted as an amplification mechanism, or impeded price discovery, or interfered with market functioning. Brainard said:

During episodes of financial turmoil, reduced liquidity can lead to outsized liquidity premiums as well as an amplification of adverse shocks on financial markets, leading prices for financial assets to fall more than they otherwise would. The resulting reductions in asset values could then have second-round effects, as highly leveraged holders of financial assets may be forced to liquidate, pushing asset prices down further and threatening the stability of the financial system.

And for the hard part, Brainard went on to note that statistical evidence of a liquidity crunch is harder to come by, particularly in day-to-day liquidity. The Fed speech even noted:

The share of bonds owned by entities that tend to hold securities until maturity, such as mutual funds and insurance companies, has increased in recent years, which would lead turnover to decline even with no change in market liquidity. In some markets, the number of large trades has declined in frequency, which could signal reduced market depth and liquidity, but could also reflect a shift in market participants’ preferences toward smaller trade sizes…

As we continue to investigate quantitative evidence of the deterioration in the resilience of liquidity in some of the financial markets, we are also trying to tease out the various drivers of liquidity conditions, such as changes in regulation, trading strategies, and market structure. Regulatory changes are often cited as a contributing factor.

As a reminder, there is turmoil around Greece in Europe, turmoil off our own shore in Puerto Rico, and there is even some turmoil about what will happen in China’s easing program. There is the upcoming beginning of a quantitative easing in the US, but Europe and Japan are in their own QE plans now. Let’s just hope that there are no economic shocks before the Fed finishes its next study and review on liquidity issues due later this year.

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