Bond market liquidity has been a subject of great debate since 2014, the year that the Federal Reserve put an end to its massive quantitative easing program. It was the biggest emergency economic stimulus in US history, an extraordinary effort that saw the Fed add more than $3.5 trillion to its balance sheet. Whether or not QE actually worked is another debate (the answer is No, by the way). The question worth exploring today is whether its demise has impacted liquidity in the US mortgage bond market.
Apparently, the answer to that question is also No, according to quartet of Federal Reserve researchers (we realize that quoting the Fed to talk about the Fed doesn’t look good on paper, but bear with us). Liquidity in the government mortgage-backed security market, as measured by bid-ask spreads and price impact, has remained relatively stable since 2011 – the year the Financial Industry Regulatory Authority first began tracking transaction data. In other words, transaction costs for agency MBS have been stable.
So, why have there been rumblings of declining liquidity in the US mortgage bond market? Mostly because trading volumes, transaction sizes and turnover rate have plummeted. But according to researchers, this has more to do with increased regulation and a huge shift in MBS ownership  than a lack of liquidity (the large decline in transactions occurred at the same time the Fed became the largest buyer of agency MBS).
A Closer Look at Bond Market Liquidity
Liquidity means a lot of different things to different people. In the bond market, it generally refers to investors’ confidence and ability to buy and sell at a reasonable price and in a timely and efficient manner. That’s why the bid-ask spread – the difference between the highest price that a buyer is willing to pay for an asset and the lowest price at which a seller is willing to sell it – is so important. The Fed researchers clearly showed that, while spreads spiked in the second half of 2013 in response to surging long-term interest rates, they soon declined and have stabilized ever since.
1 Includes GNMA, FNMA, and FHLMC mortgage-backed securities and CMOs and private-label MBS/CMOs.
Source: Richard Padjasek, Linsey Molloy, Michael Fleming and Andreas Fuster (February 8, 2016). “Has MBS Market Liquidity Deteriorated?” Federal Reserve Bank of New York.
But there are many other forces at play. The bond market is experiencing a structural change in underlying liquidity due to falling broker-dealer inventories, lower trading volumes and record corporate bond issuance. Here, it’s important to think of liquidity not just as the amount of stuff that can be traded in the market, but the cost of transacting in a market that is influenced by a myriad of factors. That’s why the bid-ask spread increases in times when liquidity is scarce. If there are fewer people buying and selling, the cost of transacting increases because infrequently traded assets are harder to convert to cash. For investors, keeping liquidity costs down is an important aspect of managing market risk.
Monitoring Liquidity amid Rising Interest Rates
While MBS market liquidity appears to be robust for now, the anticipation of higher interest rates by the Federal Reserve has raised concerns that liquidity in the bond market could dry up as investors look to sell their holdings. After all, conventional wisdom states that higher interest rates are bad for bonds, especially for shareholders in bond funds holding hundreds or even thousands of individual bonds.
The good news is we may not have to think about that for a while. The Fed clearly isn’t going to raise interest rates anytime soon and is unlikely to do so before the elections in November. This leaves December as the likely date for a second interest rate increase. Even then, investors are split, according to the CME FedWatch Tool. That’s because the US economy slowed to a crawl in the first quarter, with some estimates showing growth of only 0.2% year-on-year. That is absolutely abysmal and all the Fed needs to keep its foot on the brakes for now.
 Richard Padjasek, Linsey Molloy, Michael Fleming and Andreas Fuster (February 8, 2016). “Has MBS Market Liquidity Deteriorated?” Federal Reserve Bank of New York.
 Karan Kaul and Laurie Goodman (November 2015). Declining Agency MBS Liquidity Is Not All about Financial Regulation. Housing Finance Policy Center.
 Matt Scully (February 8, 2016). “U.S. Mortgage Bond Markets Liquid Despite Low Volumes: N.Y. Fed.” Bloomberg.
 Barbara Novick, Richard Prager, Alexis Rosenblum and Rachel Barry (February 2016). Addressing Market Liquidity: A Broader Perspective on Today’s Bond Markets.” BlackRock.
This article was written exclusively for GoRion.