Treasury Market Liquidity Takes Some Blame for Surging Yields

(Bloomberg) -- U.S. Treasury market liquidity is back in the spotlight, and not in a good way.

Liquidity has eroded in short-maturity issues in particular, and may be partially to blame for this week’s bloodbath in U.S. rates, according to JPMorgan Chase & Co. Two-year note yields leapt to the highest level since March 2020 and breakeven rates for Treasury inflation-protected securities increased to multiyear highs.  

Market-implied expectations for Federal Reserve rate hikes may be overblown as a result, JPMorgan strategists led by Jay Barry said in an Oct. 21 note.

“Market depth in the 2-year sector has continued to drop and is now significantly depressed compared to average levels observed over the last year,” they said. The move in yields has been “exaggerated by poor liquidity conditions,” and prices in “a faster liftoff path than might be warranted.”  

JPMorgan recommended a tactical long position in two-year notes on Oct. 18.

The liquidity analysis is based on the amount of bids and offers in Treasury notes and bonds between 8:30 a.m. and 10:30 a.m. New York time, when most trading activity takes place. By contrast, market depth in the intermediate sector has rebounded since August, JPMorgan says.

Meanwhile, Bloomberg’s U.S. Government Securities Liquidity Index -- a gauge of deviations in yields from a fair-value model -- has gone parabolic, rising about 70% this month. Thursday’s close was the highest since the March 2020 liquidity crisis.

In U.S. trading Friday, 2-year yields topped 0.47%, with swaps pricing in a quarter-point Fed rate increase by September 2022 and another one in December. TIPS breakevens rose further, with the 5-year rate reaching 3%.

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