on this day in 2021 ...
… The Treasury Market Flash Event of February 25, 2021
On February 25, 2021, there was an unusual "flash" event in U.S. Treasury markets. The prices of Treasury securities dropped sharply amid strained liquidity conditions, before recovering within about an hour. This event follows several similar episodes in recent years, including the flash event of October 2014, which was discussed in the Joint Staff Report on the U.S. Treasury Market on October 15, 2014 (PDF). Given the key role played by the Treasury market as the largest and most liquid sovereign bond market in the world, it is important for policymakers to understand the nature and causes of these episodes. This Note discusses what happened on February 25, what we currently know about the likely causes, and how it compares with previous similar episodes.
Leading up to the February 2021 episode, liquidity conditions in the Treasury market had largely recovered from the particularly severe episode of illiquidity that followed the onset of the COVID-19 pandemic in March 2020. The yields on Treasury securities had risen substantially from their pandemic-related troughs, in part following news of the arrival of COVID-19 vaccines and expectations of further fiscal support, as well as an increase in the issuance of longer-term Treasury securities. Since the beginning of 2021, the increase in yields became more rapid and market-implied measures of interest rate uncertainty had picked up; at the same time the volume of trading in Treasury securities rose notably.2
On February 25 itself, yields had continued their recent upward trend through the morning. Shortly after 1 p.m. yields spiked sharply higher, which market commentary linked to the release of the results of a 7-year Treasury note auction at 1 p.m. We show that trading conditions in the most liquid parts of the Treasury market deteriorated notably around the same time, with signs that liquidity provision by high-frequency market makers was insufficient to meet the heavy order flow.3 We further show that the episode was much less severe and shorter-lasting than the episode of March 2020, with the cost of trading as measured by bid-ask spreads quickly returning to normal levels. However, as of early April 2021, the total size of posted quotes on electronic order books ("market depth") has not yet fully recovered, which suggests that Treasury market liquidity may remain fragile even amid sizeable ongoing Treasury purchases by the Federal Reserve.
What Happened on February 25?
The prices of Treasury securities (which move inversely with yields) fell through the morning of February 25, amid elevated trading volumes, before dropping sharply lower shortly after 1 p.m., as shown by the black lines in Figure 1. Similar patterns were observed in prices in the Treasury futures market (not shown). The sharp spike mostly reversed within an hour, similar to some previous flash events in the Treasury market, including the flash event of October 15, 2014.
Note: Transaction prices (black dots) are expressed in dollars per $100 of par value. Five-minute total trading volume bars (blue bars) are expressed in billions of dollars. Top left panel shows transaction prices and volumes for the 2-year Treasury note; top right panel for the 5-year Treasury note; middle left panel for the 7-year Treasury note; middle right panel for the 10-year Treasury note; bottom left panel for the 20-year Treasury bond; bottom right panel for the 30-year Treasury bond. Timestamps are Eastern Standard Time.
Source: BrokerTec and authors' calculations…
… However, a couple of factors are likely relevant. First, the February 25 episode came against a backdrop of rising yields (and therefore falling prices) on longer-term Treasury securities and greater uncertainty about future yields amid heightened trading volumes. The pace with which longer-term yields (shown in Figure 3) were increasing had been particularly rapid over the previous month, and there had also been a notable increase in forward-looking measures of interest rate volatility (shown in Figure 4), particularly for the 5-year rate. This backdrop seems likely to have been an important factor that influenced both how market makers managed their risk exposures and how market participants interpreted the signal about future yields from the February 25 auction results.
Figure 3. Yields on Nominal Treasury Securities
… In summary, although the available sample of episodes of notable sudden drops in market depth is small, and the above characterization is somewhat subjective, it does appear that the amount of economic uncertainty accompanying each episode has a bearing on the time it takes for market depth to recover. That observation raises the question of whether there is a systematic relationship between the recovery time and some observed measure of uncertainty. In particular, standard market microstructure theories emphasize the negative relationship between the realized volatility of asset prices and market depth (see, for example Nguyen, Engle, Fleming and Ghysels (2020)). However, Figure 7 shows that there is little correlation between the level of the realized volatility of the 10-year Treasury yield at the start of the episode and the time taken for market depth for the 10-year Treasury to recover to 75 percent of its pre-episode level.12 Unreported results also show there is little correlation between the same measure of volatility and the initial decline in depth. Thus, it appears that volatility may not by itself be a particularly good predictor of episodes of Treasury market illiquidity, or their severity and persistence.13 Furthermore, the time it takes for liquidity to recover may also depend in part also on actions taken by policy makers.
… Conclusion
The Treasury market flash event of February 25, 2021 underscores the pivotal role of high-speed liquidity provision in the most liquid electronic parts of the Treasury market. We find evidence that the sharp drop in prices that day was accompanied by a sudden drop in market depth and a brief deterioration in high-speed liquidity provision amid elevated transaction volumes, albeit to a much lesser extent than during the episode of severe illiquidity in March 2020. Similar to some previous episodes accompanied by moderately elevated economic and financial market uncertainty, market depth has recovered steadily since February 25 at a pace comparable to that observed following other such episodes, while high-speed liquidity provision appears to have rebounded fairly quickly. That said, market depth has taken over a month to partially recover, which suggests that Treasury market liquidity has been more heavily reliant on high-speed replenishment to meet trading demand and may remain fragile.
Oh … and aside from the flash crash, on this day in 1970
… and then there was this fight lots of folks still talk ‘bout … AND … THAT is all for now … more on the flipside