Optimal Measure and Drivers of U.S. Treasury Market (Il)Liquidity: Will Low Liquidity Be the New Normal?

Recent bouts of volatility in the Treasury market, exacerbated by stubbornly depressed liquidity, have caught the attention of a large number of market participants. In this article, the authors compare several popular measures of U.S. Treasury market liquidity and attempt to identify the driving forces behind the recent decline. Their analysis shows that Treasury market depth is the best measure of liquidity, as it has historically done an excellent job in forecasting volatility and is conceptually more appealing than other popular measures, such as bid–ask spreads and trading volume. Although uncertainty regarding the path of U.S. monetary policy has been partly responsible for the recent decline in liquidity, the authors suggest that structural changes in the marketplace have helped aggravate the situation. Increasingly active queue management has led market makers to withdraw liquidity in times of heightened volatility, and regulatory constraints have restricted dealers’ ability to provide liquidity, because they are incentivized to hold smaller inventories than in the past and are generally more risk averse.