The Federal Reserve doesn’t see signs of liquidity problems in U.S. bond markets, despite warnings from investors to the contrary.
“While market commentary increasingly pointed to a possible deterioration in liquidity in these markets, a variety of liquidity metrics — including bid-asked spreads and bid sizes — have displayed no notable signs of liquidity pressures over the past half-year,” the Fed board said Wednesday in the U.S. central bank’s semi-annual monetary policy report to Congress.
U.S. regulators said in a report Monday that sharp swings in the Treasury market on Oct. 15 were in part caused by the abrupt withdrawal of buy offers by banks, exacerbated by multiple orders from high-frequency traders that canceled each other out.
Treasury yields plunged and then rose, covering a 37-basis-point range during a 12-minute period starting at 9:33 a.m., an intraday change that has only been exceeded three times since 1998. Those occasions, unlike the Oct. 15 move, were driven by significant policy announcements.
Financial firms have complained that a series of rules implemented under the 2010 Dodd-Frank Act have reduced liquidity in the bond market and exacerbated price swings.
“All told, while the current level of liquidity in the on-the-run interdealer market seems healthy, some aspects of price movements and liquidity metrics in this market warrant careful monitoring,” the Fed board said in its report.
Market participants take a less sanguine view of liquidity in Treasurys trading. According to a January report by JPMorgan Chase & Co., it took an $80 million order of 10-year notes to move the market, down from $280 million a year earlier.
The 22 primary dealers that serve as counterparties to the Fed have traded a daily average of $505 billion in Treasurys this year, down from $521 billion in 2012, central bank data show.
While dealers have less inventory and price swings may have increased, “the market remains the most liquid market in the world,” said Mark MacQueen, partner in Austin, Texas, at Sage Advisory Services Ltd., which oversees $11 billion. “Yes, the market’s become more difficult, but the market always becomes more difficult when volatility increases.”
The Bank of America Merrill Lynch Option Volatility Estimate index, at 80.80 Tuesday, is up from 54.03 a year ago as the Fed has ended bond purchases and begun preparing investors for a potential interest-rate increase.
In a section on financial stability, the Fed board said risks remained moderate.
“Large banking firms’ direct net exposures to Greece are low, although financial vulnerabilities from the situation could become more concerning if large European counterparties were weakened by a significant deterioration in peripheral European countries,” the report said.
Credit markets have shown “some signs of reach-for-yield behavior,” the report said, while underwriting standards on leveraged loans “remain weak” even as regulatory guidance appears to be slowing issuance.
“The share of loans — mostly those for middle-market companies — originated by nonbank lenders reportedly has increased a bit further,” the report said.
Commercial real-estate property prices continue to increase rapidly, and underwriting standards in that market have loosened, the report said.
The report also noted that large redemptions at mutual funds that hold less liquid bonds “might amplify volatility” in a period of rising long-term rates.
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