Treasury market liquidity erodes with Fed price a bet

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(Bloomberg) – Liquidity is eroding again in the U.S. Treasury market, as last week’s controversy over how much and how quickly the Federal Reserve will raise interest rates this year sparked a wave of extreme volatility of returns.

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The Bloomberg US Government Securities Liquidity Index – an indicator of yield deviations from a fair value model – is nearing last year’s highs reached in early November. At that time, expectations for Fed hikes had started to rise in October, causing historically large daily swings in short-term Treasury yields in particular.

In the latest iteration, the prospect that the central bank – which normally changes its key rate in quarter-percentage-point increments – might consider a half-point rate hike in March pushed the yield on the note higher. two years to increase by 21 basis points. on February 10, its biggest rise since 2009. On the same day, an indicator of expected US rate volatility over the next 12 months hit its highest level since May 2010, a time of spectacular volatility for US equities.

“Any real depth of liquidity is shallow,” Peter Tchir, head of macro strategy at Academy Securities, said in a roundtable discussion on the Bloomberg TOPLive blog on Tuesday. In Treasury bills, older securities “trade very poorly, a sign of this lack of liquidity”.

Related: Rate Volatility at Mayhem Highs in 2010 Attracts $35 Million Sell

“As volatility has accelerated, market depth has diminished,” US interest rate strategists at JPMorgan Chase & Co. led by Jay Barry said in a Feb. 11 note. The “lower liquidity in the Treasury market has acted as an accelerator in the latest moves,” they said. Market depth — derived from the size of the top three bids and offers on the BrokerTec trading system between 8:30 a.m. and 10:30 a.m. in New York — is depressed for all Treasury tenors, and worse for two-year notes only for 5 and 10 year olds.

With short positions anticipating higher higher yields and continuing to grow, liquidity will be essential to avoid a dramatic repricing in yield should a reversal in sentiment cause investors to exit these positions.

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