Some 16 months after the “flash rally” in U.S. Treasuries blindsided Wall Street traders, little about what exactly went wrong has been resolved. The most common, albeit tenuous, explanation is that the futures market seized up that morning, creating a spillover effect into cash bonds that led to a frenetic 12-minute spike in prices.
JPMorgan Chase & Co. analysts are now advancing a new theory, one they contend is a key to how to trade most effectively in today’s volatile Treasuries market. The problems on Oct. 15, 2014, actually began in the cash market, the analysts led by Joshua Younger said in a note this week.
Among the evidence they cite is the fact that it was much easier to trade in the futures market that day, a trend that continues now and makes futures the place that they and other big players say investors should turn when looking to trade the Treasuries market.
“The data suggest the cash market broke first,” Younger said in a phone interview Thursday. “Futures were playing catch-up, to some extent.”
The ongoing analysis of what happened that day illuminates recent shifts in the mechanics of the $13.2 trillion market that have made its derivatives relatively easier to trade, according to Younger and his colleagues. Since the financial crisis, overnight financing markets have gotten crunched, regulations have shrunk bank balance sheets and a disconnect has grown between investors, who often trade over the phone one-on-one with dealers, and ultra-fast market makers trading on central platforms. It typically requires more capital to trade in bonds than to transact in futures.
Those changes are in the spotlight as the Treasury Department conducts its first significant review of the market in almost two decades after asking participants on Jan. 19 for comments about liquidity.
Some big names back JPMorgan’s view that it’s often tougher to trade Treasury securities in the roughly $500 billion-a-day cash market than the derivatives that track them. The Federal Reserve Bank of New York touched on the topic in a recent blog post. Sam Priyadarshi, head of fixed-income derivatives trading at Valley Forge, Pennsylvania-based Vanguard Group Inc., the largest private holder of Treasuries, says the relative ease is encouraging his team to trade more in futures. His team trades Treasuries for some of the firm’s active portfolios.
The JPMorgan analysts looked at measures of trading activity and the depth of the markets’ liquidity to determine the source of the steep drop in yields in October 2014. They found that shortly before the decline, volume in 10-year Treasury notes spiked. In contrast, trading volume in 10-year futures contracts only peaked after the note’s yield had plummeted to its low for that day, they said. They also found that, in futures, average transaction costs were lower, and distribution of market depth across the order book was more stable.
“Even after more than a year, the events of October 15, 2014, remain seared in the market’s collective memory,” the analysts wrote. “It remains an invaluable laboratory for what can go wrong — and increasingly does these days.”
Younger pointed to Feb. 11, when the 10-year Treasury yield slid to intraday lows around 1.53 percent — the lowest in more than three years — before rebounding within roughly an hour.
“That lesser breakdown looks similar in many ways to October 15, 2014, with cash volumes elevated relative to futures around the lows in yield,” the analysts wrote.
Recent regulations make it less profitable for bond dealers to hold U.S. debt on their balance sheets. Yet nearly all investors need to go to a dealer to trade it, according to a Feb. 12 blog post from the New York Fed.
Trading futures is more efficient since it’s not as capital-intensive, and he can see trades being reported in real time, Vanguard’s Priyadarshi said. What’s more, he can use algorithms to trade directly and anonymously on central venues, which he can’t do in the Treasury market.
He said that’s a big reason for the popularity of the “Ultra” 10-year Treasury note futures contract introduced by CME Group Inc. last month. It saw more trading volume in its first seven weeks than any other new contract in CME’s history, according to the exchange.
“There will be a lot of people who use this as a proxy for the 10-year note,” Priyadarshi said.
It’s not yet clear whether the new contract will lure investors who don’t normally invest in futures, which could steer the market more toward futures, Wall Street strategists say. Instead, it might just draw demand from the existing contract, which happened when CME Group introduced a similar contract for long-term debt, according to Bank of America Merrill Lynch in New York.
Still, JPMorgan’s analysts expect the shift will continue.
“To the extent that the relative resilience of futures markets persists through these episodes, it will serve to reinforce this structural shift away from cash” Treasuries, they said.