Leverage, illiquidity, concentration. The higher these are, the more vulnerable the market is. I’ve written posts over the past while about leverage and concentration. (See Assessing Market Vulnerability and Rick published in the Investments and Wealth Institute) These are dropping from their peaks, but still are at a high level — top decile based on thirty years of history.
There are plenty of data sets that give a read on concentration and leverage. Illiquidity is harder to measure. What is going on day to day doesn’t give a sense of what liquidity will be like when it really matters, when everyone is heading towards the de-risking door. And maybe being pushed out the door because of leverage-induced forced liquidations.
But we can get a sense of what is going on for the most critical and liquid of markets: U.S. Treasuries.
As the chart here shows, volume is down to the lowest level in the past 20 years, down to half of what it was a decade ago.
.png?width=2287&height=1424&name=Treasury%20volume%20(as%20percent%20of%20market%20size).png)
Furthermore, market depth has dropped precipitously over the past few years. (Market depth is measured here by the size of a trade that leads to a market impact. Taken from an analysis by Alliance Bernstein.)
.png?width=2019&height=1232&name=Treasury%20market%20depth%20(10-year).png)
The illiquidity in the Treasury market matters a lot. It is the critical lubricant for a wide set of other markets. The fuel for markets, the money markets and repo. And the essential tool for risk management of other bonds, whether hedging short or long positions. If you are a broker/dealer, you are not going to hold much inventory if it is hard to hedge your book, and that means lower liquidity for the bond market in general.So, not good news.
