MNI: US Treasury Liquidity Strains Could Be Costly -Fed Report

The Federal Reserve said Friday historically low quote volumes in the Treasury market in recent months could mean trading costs are at risk of rising sharply during volatile periods, though the market continues to function smoothly overall.

Bid-ask spreads for 2-year and 10-year Treasuries have moved higher since spring, while heightened volatility caused by the uncertain economic outlook is translating into lower liquidity, the report notes.

"The Treasury market has continued to function smoothly over the period from the May report, but measures of trading costs have remained moderately elevated and liquidity appears to be less resilient than is typical," according to the Fed's semiannual Financial Stability Report.

"These liquidity strains appear to be primarily a consequence of the elevated interest rate volatility associated with uncertainty about the economic outlook. While measures of trading costs such as bid-ask spreads are only moderately elevated, the fact that intermediaries are posting historically low volumes of quotes may mean that the risk of a sharp further increase in trading costs could be higher than usual."

Ex-RBI Governor Raghuram Rajan told MNI in a September interview that the Fed's QT program could trigger another liquidity crunch.

HOUSING VALUATIONS HIGH

Liquidity conditions in various other major markets are also moderately strained, the monetary authority said.

Overall vulnerabilities related to financial sector leverage remained moderate, the Fed said. "Hidden pockets" of high leverage in nonbank financial firms could serve to amplify adverse shocks, but the exposures are difficult to monitor because of limited data, the Fed said.

Asset valuations have declined to roughly average levels, though house prices and rents are still high, the Fed said.

"Risk premiums in equity and corporate bond markets were near the middle of their historical distributions. In contrast, property markets still show elevated valuations."