A few weeks ago, I read a Bloomberg article that quoted bond traders as saying, “Liquidity is there in the world’s biggest bond market, except when you really need it.” The quote immediately brought me back to my childhood. I remember numerous summer days when my Dad brought home a “new” snowblower he found sitting lifeless on the side of the road. Excited about his new toy, he would make some tweaks, and soon have his new prized possession purring like a kitten. Fast forward six months into the heart of a New England winter, and my frustrated father would be handing out shovels to my brothers and me, who cursed without remorse. If you live in New England and don’t want to drop a lot of money on snow removal, you may know this story all too well.
In many ways, liquidity in the rates market pre-COVID was like my Dad’s snowblower in July, purring like a kitten. It was effortless to move in and out of positions, and bid/ask spreads were at historic tights, keeping transaction costs extremely low. Fast forward to March 2020, and within a matter of days, COVID headlines managed to dehydrate the most liquid market in the world. As ground zero for the bond market, the US Treasury market sets the tone for all sub-sectors within fixed income. When liquidity is compromised, the Federal Reserve Board (Fed) tries to swiftly restore normalcy to the markets. In March 2020, the Fed had a plan to fix liquidity in rates, and in large part, the plan worked.
Disrupted liquidity in the world’s most trusted market isn’t as foreign a concept as some may think. As you may recall, in October 2014, the Treasury market experienced a “Flash Crash,” which abruptly sent yields materially lower in a matter of minutes. This sharp and severe move quickly captured headlines and forced investors to question the market’s overall depth. Even after dissecting the circumstances of the event, US officials were never able to really explain the large intraday swing in Treasury yields.
Over the last 10 years or so, the rates market has truly evolved. On the supply side, the US Treasury has been auctioning off bonds at a record pace. Stimulus-related costs have further fueled the Treasury’s debt needs, and the resulting supply isn’t always digestible. In February 2021, the Treasury held a 7-year auction that many expected would be well-received. When demand for the bonds faltered, primary dealers stepped in and took down almost half of the auction, pressuring the belly of the curve. The volatility that followed served as a stark reminder that, while the system has stabilized since March 2020, liquidity continues to ebb and flow.
To be clear, liquidity in Treasuries, even on their worst day in March 2020, was, and always will be, better than that of most bonds. Many trades are put out on an electronic exchange; we request quotes from a handful of dealers and execute at the best price available. On the other side of the trade, the largest broker/dealers in the world use finely-tuned algorithmic trading models to provide quotes in fractions of a second; the competition is fierce. In the world of Treasury trading, when liquidity begins to sour, we often notice bid/ask spreads widening modestly. As traders, we are constantly monitoring bid/ask spreads across the entire Treasury curve. If softness creeps into the market, we know where to check for cracks, and how to use available data to determine the actual strength of liquidity.
Looking back at March 2020, deep off-the-run bonds were hit first, with bid/ask spreads far exceeding anything we had seen in the recent past. While there was never a time when we couldn’t execute, we were selective in what we bought and sold, especially when costs were elevated. As a fiduciary, we are focused on minimizing transaction costs and acting in our clients’ best interests. So, when participants say, “liquidity isn’t there when you really need it,” what they mean is, transaction costs tend to be higher when you’re most likely to transact. During these times, we are often buying/selling for client contributions/withdrawals, or selling Treasuries to take advantage of opportunities stemming from more volatile and dislocated markets.
Since March 2020, we’ve had a few liquidity hiccups, but nothing nearly as disruptive. The Fed’s prompt action put us back on the path to normalcy – at least from a rates’ trading perspective. However, there is one lasting dynamic in our market. We continue to benefit from the Fed’s ongoing purchases of $80bn in securities, month in and month out. As we near pre-COVID liquidity, all market participants have the same burning question in the back of their minds. What happens if the Fed steps away? Will this market continue to function with such a high level of liquidity?
We have all seen those days – the economic news is mostly positive, counterparties are hungry to transact, and as a result, liquidity feels abundant. On those days, it’s easy to suggest that the Fed needs to turn off the printer and let the market fly on its own! It’s 77 degrees and sunny, and the snowblower is roaring like a lion, able to push aside whatever snow lies in its path. But as we’ve learned, bouts of volatility can emerge in a flash, reminding us that, while the system has stabilized since March 2020, liquidity will continue to fluctuate with market conditions. Even with the Fed’s heavy purchases each month, at times, market participants can find themselves pulling the ripcord on a snowblower that just doesn’t like the cold.
