Janet Yellen isn't worried about bond market liquidity

While everyone from Bill Gross to Howard Marks seems to be worried about bond market liquidity, Federal Reserve Chair Janet Yellen is not.

Alongside Yellen’s testimony before the House Financial Services Committee on Wednesday, The Federal Reserve released the central bank’s semiannual Monetary Policy Report.

In the report, the Fed acknowledged the growing liquidity concerns in fixed income markets, but was more or less dismissive of investors’ uneasiness on the topic.

Here’s the Fed:

Despite these increased market discussions, a variety of metrics of liquidity in the nominal Treasury market do not indicate notable deteriorations. For example, bid-asked spreads for the on-the-run 10-year Treasury security have remained at levels comparable with or even slightly narrower than those observed before the recent financial crisis (figure A). A measure of market depth has shown notable variation since the data became available in 2010 and is currently around its average level in 2010 and 2011 (figure B).

The Fed did recognise, however, that high frequency trading could mask both these measures, and thus potentially compromise their ability to indicate market liquidity.

The report also dismissed concerns about liquidity in the corporate bond market.

“Some analysts raised concerns that the rise of buy-and-hold investors and the decline in dealer inventories relative to the outstanding amount over the past few years may have negatively affected the prospects for liquidity conditions in the corporate bond market, especially during episodes of financial stress,” the report said.

“So far, however, corporate bond market liquidity as captured by conventional measures has not experienced substantial deterioration during recent episodes of stress in fixed-income markets, such as the sharp increase in Treasury rates in the summer of 2013 or the flash rally of October 15, 2014.”

On October 15, 2014, the 10-year US Treasury note fell 34 basis points, or 0.34%, to as low as 1.86% in just a matter of minutes. And as Jamie Dimon, CEO of JPMorgan, noted in a letter to investors in April, this is the kind of event that is supposed to open just once in every 3 billion years.

The Fed’s report added that, “Similar to the Treasury market, a range of conventional liquidity metrics in corporate bond markets also generally do not point to a significant deterioration of market liquidity in recent years.”

In a note to clients on Wednesday, Citi’s William Lee characterised the Fed’s report as “surprisingly complacent” about liquidity risks, especially as the Fed prepares for rate normalization.

“Our unease is not about the availability of liquidity under normal market conditions, but its obtain ability when the Fed is engaged in rate normalization,” Lee wrote.

“Will the normalization of asset allocations (especially involving less liquid securities) that accompany the Fed’s interest rate normalization process (even one with a very gradual increase) be so ‘large and lumpy’ as to overwhelm current market making capabilities?”

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