What's Behind the Drop in Treasury Market Liquidity?

In a year shrouded by turmoil, 2022 has been one for the record books. Financial markets have been upended by historically high inflation, soaring interest rates, dissolution in global trade and armed conflict in Ukraine. This has led to volatility affecting all corners of the financial markets.

With the year winding down, investors might think they’ve seen it all. But one element of market disfunction that’s largely flown under the radar is increased friction within the US Treasury market. Treasuries are experiencing a liquidity decline on the back of economic uncertainty and higher volatility, with large blocks of government debt increasingly hard to trade.

Given this market’s importance to global financial stability, it should come as no surprise that the issue is finally starting to attract notice.

Shrinking the Fed’s Bloated Balance Sheet

The Federal Reserve has a dual mandate—maximum employment and stable prices—but the Federal Open Market Committee has focused primarily on employment since the global financial crisis (GFC). After all, inflation hadn’t been a point of concern for decades leading up to 2021.

Following the economic turmoil of the GFC, the Fed lowered the fed funds rate to the zero lower bound and rolled out quantitative easing (QE) as a favored monetary tool in its efforts to lower rates and stimulate the economy.