Beware of Misleading Trading in U.S. Treasuries

Why the combination of lower volatility and reduced trading volumes have some analysts worried about what the future holds for the Treasuries market.

Just because U.S. Treasuries look more and more stable doesn’t mean they are.

With trading volumes plunging, the lack of volatility may be more a result of the market becoming less liquid as the Federal Reserve hoards trillions of dollars of bonds and banks pull back from debt trading, not because there’s less risk.

Historically, lower volatility has meant more—not less—trading. What’s happening instead is that unprecedented central-bank stimulus has sent everyone into the same risk-on bets, while it’s also becoming more difficult to trade as banks shore up their balance sheets in the face of new regulations.

“We blame the wave of central-bank liquidity, which has pushed up asset prices irrespective of fundamentals,” Citigroup Inc. strategists led by Matt King in London wrote in a note today. “This creates a vicious circle: ever-higher prices, ever-less trading and liquidity.”

Fed policy makers will reduce their monthly asset purchases to $35 billion, from $45 billion, when they gather in Washington today, according to the median analyst estimate compiled by Bloomberg.

Yields on 10-year Treasuries have fluctuated within a 0.59 percentage point range on a closing basis this year, compared with 1.4 percentage points last year and 0.99 percentage-point in 2012, according to Bloomberg Bond Trader data. Yields were at 2.63 percent as of 11:56 a.m. in New York, below the average 3.9 percent since the beginning of 2000.

 

Trading Slump

Lower volatility used to lead to more trading before the 2008 financial crisis. The opposite has been the case since then, as the Fed has held its benchmark rate near zero and bought trillions of dollars of Treasuries and mortgage debt.

The average volume of Treasuries traded each day has fallen to $504 billion this year from $545 billion in 2013 and as high as $570 billion in 2007, according to data compiled by the Securities Industry and Financial Markets Association. From 2002 to 2006, U.S. government-debt volumes rose 43 percent.

The drop in trading comes as a measure of volatility in Treasury yields has fallen 69 percent since 2008, according to Bank of America Merrill Lynch’s MOVE Index.

The explosion of fixed-income derivatives trading also speaks to the difficulty investors are having buying and selling bonds. As bond trading has slumped, the notional value of over-the-counter futures contracts has soared, based on the latest data from the Bank for International Settlements compiled by Deutsche Bank AG.

Meanwhile, yields on riskier assets are dropping faster than those on safer securities as investors pile into already-crowded trades. The gap between yields on junk bonds and investment-grade notes has shrunk to 2.99 percentage points, the least since 2007, Bank of America Merrill Lynch index data show.

Here’s why analysts are zeroing in on trading volumes: They’re trying to figure out what happens to bonds when the Fed entirely yanks its stimulus. The concern is that the lack of trading on the way up in the market is a harbinger of poor liquidity on the way down—or more volatility as investors head in the opposite direction.

In other words, that could mean more pain for investors.

“The markets’ mojo is gone, and we’re not sure it’s coming back,” Citigroup’s King wrote. “Beware when the tide goes out.”

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