When it comes to bond trading, liquidity is a major factor. Being able to buy and sell without the trade nudging the bond's price has a deep impact on the way that investors make trade decisions and, ultimately, the market as a whole. What's more, many analysts see levels of bond liquidity as an indicator of overall economic health, and liquidity concerns racked the markets leading up to and during the 2008 financial crisis. While low liquidity levels in the bond market earlier in 2016 prompted fears about a return to recession, in recent months there have been indicators that bond liquidity is moving back up.

Early 2016 Liquidity Scare

Widespread concern about bond liquidity in early 2016 shook up the market. In fact, liquidity levels were so low that even the market for U.S. Treasuries, generally considered to be the most liquid available worldwide, was affected. As a result, buyers of U.S. Treasuries tended toward newer debt, securities that are so-called "on-the-run" and which can be sold more easily. In many cases, premiums for these securities were twice that of older, "off-the-run" options. A number of factors may have contributed to the changes in market liquidity levels a few months back, including overall turmoil in the market and a resulting tendency for investors to turn toward safer assets. Additionally, many emerging market central banks decided to sell Treasuries to boost their economies. More general for industry experts, and perhaps more troubling, was the idea that new regulations put in place after the 2008 crisis designed to prevent subsequent turmoil might have instead damaged the bond market's ability to function properly.

Recent Good News on Liquidity

In at least one major area of the bond market, late-summer 2016 trends are showing more positive signs for liquidity and investor confidence is rising. Treasuries were used as collateral for roughly half of all tri-party repurchase-agreement transactions in July of 2016. That market, comprising about USD$1.6 trillion, is a significant one. And the indication that Treasuries liquidity is up comes as their use as collateral reached its highest levels since 2010.

A change in regulation may be responsible for the shift. By bolstering demand for repos with Treasury backing, it is likely that the repo markets will see an uptick. Trading levels in the Treasuries market are likely to follow suit. If this occurs, it will provide some much-needed reassurance to a market that has been plagued by tremors with no obvious causes since the financial crisis. It would also be welcome news for the repo market, which has declined by nearly half since it reached its highest level of about USD$2.8 trillion in 2008.

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