Michael Fleming and Claire Nelson
Policymakers and market participants are closely watching liquidity conditions in the U.S. Treasury securities market. Such conditions matter because liquidity is crucial to the many important uses of Treasury securities in financial markets. But just how liquid has the market been and how unusual is the liquidity given the higher-than-usual volatility? In this post, we assess the recent evolution of Treasury market liquidity and its relationship with price volatility and find that while the market has been less liquid in 2022, it has not been unusually illiquid after accounting for the high level of volatility.
Why Liquidity Matters
The U.S. Treasury securities market is the largest and most liquid government securities market in the world. Treasury securities are used to finance the U.S. government, to manage interest rate risk, as a risk-free benchmark for pricing other financial instruments, and by the Federal Reserve in implementing monetary policy. Having a liquid market is important for all these purposes and thus of great interest to market participants and policymakers alike.
Measuring Liquidity
Liquidity typically refers to the cost of quickly converting an asset into cash (or vice versa) and is measured in a variety of ways. We consider three commonly used measures, calculated using high-frequency data from the interdealer market: bid-ask spreads, order book depth, and price impact. The measures are for the most recently auctioned
(on-the-run) two-, five-, and ten-year notes (the three most actively traded Treasury securities, as shown in this post) and are calculated for New York trading hours (defined as 7 a.m. to 5 p.m.). Our data source is BrokerTec, whichis estimatedto account for 80 percent of trading in the electronic interdealer broker market.
The Market Has Been Relatively Illiquid in 2022
The bid-ask spread—the difference between the lowest ask price and the highest bid price for a security—is one of the most popular liquidity measures. As shown in the chart below, bid-ask spreads have widened out in 2022, but have remained well below the levels observed during the COVID-related disruptions of March 2020 (examined in this post). The widening has been somewhat greater for the two-year note relative to its average and relative to its level in March 2020.
Bid-Ask Spreads Have Widened Modestly
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. Depth levels again point to relatively poor liquidity in 2022, but with the differences across securities more striking. Depth in the two-year note has been at levels commensurate with those of March 2020, whereas depth in the five-year note has remained somewhat higher—and depth in the ten-year note appreciably higher—than the levels of March 2020.
Order Book Depth Lowest since March 2020
Measures of the price impact of trades also suggest a notable deterioration of liquidity. The next chart plots the estimated price impact per $100 million in net order flow (that is, buyer-initiated trading volume less seller-initiated trading volume). A higher price impact suggests reduced liquidity.Price impact has been high this year, and again more notably so for the two-year note relative to the March 2020 episode. That said, price impact looks to have peaked in late June and July, and to have declined most recently (in October).
Price Impact Highest since March 2020
Note that we start our analysis of liquidity in this post in 2019 and not earlier. One reason is to highlight the developments in 2022. Another reason is that the minimum price increment for the two-year note was halved in late 2018, creating a break in the note’s bid-ask spread and depth series. Longer time series of bid-ask spreads, order book depth, and price impact are plotted in this post and this paper. The longer history indicates that the price impact in the two-year note is currently at levels comparable to those seen during the 2007-09 global financial crisis, as well as in March 2020.
Volatility Has Also Been High
Pandemic-induced supply disruptions, high inflation, policy uncertainty, and geopolitical conflict have led to a sizable increase in uncertainty about the expected path of interest rates, resulting in high price volatility in 2022, as shown in the next chart. As with liquidity, volatility has been especially high lately for the two-year note relative to its history, likely reflecting the importance of near-term monetary policy uncertainty in explaining the current episode. Volatility has caused market makers to widen their bid-ask spreads and post less depth at any given price (to manage the increased risk of taking on positions), and for the price impact of trades to increase, illustrating the well-known negative relationship between volatility and liquidity.
Price Volatility Highest since March 2020
Liquidity Has Tracked Volatility
To assess whether liquidity has been unusual given the level of volatility, we provide a scatter plot of price impact against volatility for the five-year note in the chart below. The chart shows that the 2022 observations (in blue) fall in line with the historical relationship. That is, the current level of liquidity is consistent with the current level of volatility, as implied by the historical relationship between these two variables. This is true for the ten-year note as well, whereas for the two-year note the evidence points to somewhat higher-than-expected price impact given the volatility in 2022 (as also occurred in fall 2008 and March 2020).
Liquidity and Volatility in Line with Historical Relationship
The preceding analysis is based on realized price volatility—that is, on how much prices are actually changing. We repeated the analysis with implied (or expected) price volatility, as measured by the ICE BofAML MOVE Index, and found similar results for 2022. That is, liquidity for the five- and ten-year notes is in line with the historical relationship between liquidity and expected volatility, whereas liquidity is somewhat worse for the two-year note.
Note also that while liquidity may not be especially high relative to volatility, one might then ask whether volatility itself is unusually high. Answering this question is beyond our scope here, although we will note that there are good reasons for volatility to be high, as discussed above.
Trading Volume Has Been High
Despite the high volatility and illiquidity, trading volume has held up this year. High trading volume amid high illiquidity is common in the Treasury market, and was also observed during the market disruptions aroundthe near-failure of Long-Term Capital Management(seethis paper), during the 2007-09 financial crisis (seethis paper), during the October 15, 2014, flash rally (see this post), and during the COVID-19-related disruptions of March 2020 (see this post). Periods of high uncertainty are associated with high volatility and illiquidity but also high trading demand.
Nothing to Be Concerned About?
Not exactly. While Treasury market liquidity has been in line with volatility, there are still reasons to be cautious. The market’s capacity to smoothly handle large flows has been of ongoing concern since March 2020, as discussed in this paper, as Treasury debt outstanding continues to grow. Moreover, lower-than-usual liquidity implies that a liquidity shock will have larger-than-usual effects on prices and perhaps be more likely to precipitate a negative feedback loop between security sales, volatility, and illiquidity. Close monitoring of Treasury market liquidity—and continued efforts to improve the market’s resilience—remain important.
Michael J. Fleming is the head of Capital Markets Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.
Claire Nelson is a research analyst in the Bank’s Research and Statistics Group.
How to cite this post:
Michael Fleming and Claire Nelson, “How Liquid Has the Treasury Market Been in 2022?,” Federal Reserve Bank of New York Liberty Street Economics, November 15, 2022, https://libertystreeteconomics.newyorkfed.org/2022/11/how-liquid-has-the-treasury-market-been-in-2022/.
Related reading:
Treasury Market Liquidity during the COVID-19 Crisis (April 2020)
Treasury Market Liquidity and the Federal Reserve during the COVID-19 Pandemic (May 2020)
The Evolution of Treasury Market Liquidity: Evidence from 30 Years of Limit Order Book Data (Staff Report, November 2017, revised September 2022)
How Does Tick Size Affect Treasury Market Quality? (January 2020)
Liquidity and Volatility in the U.S. Treasury Market (Staff Report, December 2012, revised November 2018)
Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).
As an expert in financial markets and liquidity, I bring extensive knowledge and experience to the analysis of the recent evolution of liquidity conditions in the U.S. Treasury securities market, as discussed by Michael Fleming and Claire Nelson in their article dated November 15, 2022.
Firstly, it's crucial to understand the significance of liquidity in the U.S. Treasury securities market. Liquidity is fundamental for various purposes, including financing the U.S. government, managing interest rate risk, serving as a risk-free benchmark, and supporting the implementation of monetary policy by the Federal Reserve.
The authors utilize three common measures of liquidity: bid-ask spreads, order book depth, and price impact. Bid-ask spreads, representing the difference between the lowest ask and highest bid prices, have widened in 2022 but remain below the levels observed during the disruptions of March 2020. Order book depth, measuring the average quantity of securities available for sale or purchase at the best bid and offer prices, indicates relatively poor liquidity in 2022, with variations across different Treasury securities. Price impact, reflecting the estimated impact on prices per $100 million in net order flow, suggests a notable deterioration in liquidity, particularly for the two-year note.
The analysis extends to the historical context, comparing liquidity in 2022 to previous crises, such as the 2007-09 global financial crisis and March 2020. The authors highlight that the price impact for the two-year note is currently at levels comparable to those seen during the 2007-09 crisis and March 2020.
Volatility in 2022 has been high due to various factors, including pandemic-induced supply disruptions, high inflation, policy uncertainty, and geopolitical conflicts. The article illustrates the negative relationship between volatility and liquidity, explaining how market makers widen bid-ask spreads and reduce depth in response to increased risk.
To assess the relationship between liquidity and volatility, the authors present a scatter plot of price impact against volatility for the five-year note. The analysis suggests that, overall, the 2022 observations align with historical patterns, except for the two-year note, which shows somewhat higher-than-expected price impact given the volatility.
Despite the challenges of high volatility and illiquidity, trading volume has remained high in 2022. The article notes that periods of uncertainty are associated with both high volatility and illiquidity but also high trading demand.
While the article suggests that Treasury market liquidity has been in line with volatility, it emphasizes caution. Concerns include the market's capacity to handle large flows smoothly, especially as Treasury debt outstanding continues to grow. Lower-than-usual liquidity may amplify the effects of a liquidity shock on prices, potentially leading to a negative feedback loop between security sales, volatility, and illiquidity.
In conclusion, the analysis provided by Fleming and Nelson offers a comprehensive understanding of the liquidity conditions in the U.S. Treasury securities market in 2022, backed by evidence and historical context. The article underscores the importance of continued monitoring and efforts to enhance the market's resilience in the face of evolving economic conditions.
