The large selloff in UST on Friday has left many wondering what happened. While the jobs report was certainly a catalyst, it wasn’t really out of line with prior months. It’s not as if credit markets were suddenly awakened to the possibility that Yellen’s FOMC may do what it says, so I don’t think that the Establishment Survey provided any more emphasis than what had already existed (especially since other data last week was the exact opposite).

Whatever the ultimate catalyst, the scope of the move was undoubtedly a feature of illiquidity. The lack of systemic capacity even in UST works in both directions, so where you can get a huge move in October 15 in one direction it isn’t entirely unrealistic to see the opposite a few months later – especially with another “buying panic” occurring in between. Those two events pushed nominal yields down quite far, quite fast, making a retracement unsurprising.

The degree of that one-day move on Friday simply highlights yet again how even UST trading is but a shell of itself. That is a huge weak spot and continues to suggest difficulties ahead, especially as funding participants and dealers themselves have to calculate more volatility. It isn’t appreciated widely enough, but the extent of contraction in liquidity supply is astounding.

Since then [October 15], the ability to trade Treasuries quickly and easily has shown few signs of improving. JPMorgan, one of the 22 primary dealers that trade with the Fed, estimates the amount of 10-year notes available to buy or sell at one time without moving prices has fallen more than 70 percent in the past year.

There are a few cross-currents that explain that attrition, both of which are likely tied to QE and monetary policy rather than “macroprudential” regulation. I described last week, using the FDIC’s Quarterly Banking Profile, how the structural changes with regard to wholesale funding have combined with more cyclical alterations in bank behavior. The net result, which is indicated in the quoted passage above, has been less wholesale funding available to soak up any changes in selling/buying dynamics.

Without a robust wholesale system, banks themselves have been “hoarding” UST collateral, removing them from available circulation in repo – in addition to the trillions taken out by QE. In short, banks are self-insuring their own liquidity by increasing their allocations (static) to UST’s in their portfolios. We often think of treasuries only in terms of “flight to safety”, but in this respect they act as a liquidity buffer against both broader collateral shortages and sharp rises in volatility risk calculations. If wholesale funding had no so drastically eroded under QE, I think it likely that such hoarding would have been avoided or at least considerably reduced.

ABOOK Feb 2015 QBR Funding GapABOOK Feb 2015 QBR UST Nominal

These problems were further exacerbated last week by the massive amount of corporate supply, only some of which (still a good proportion) was related to Actavis floating a huge issue. Dealers were undoubtedly committing a high proportion of resources to ensuring successful offerings in corporates (where they make their money nowadays) leaving little left to absorb factor changes in UST.

With such diminished capacity, dealers focusing elsewhere simply left the treasury market highly vulnerable to a change in condition. Whatever the catalyst, there was nothing left to absorb the increase in selling, even mild as it may have been.

Now the question is whether Friday’s big move represents an inflection away from bearishness in credit toward something closer to what the FOMC continues to proclaim. My view is that all that has changed is the nominal situation of the UST curve, as almost everything else remains as it was prior. Again, I believe the “buying panics” of those two liquidity events pushed nominal yields down too far, too fast, and an “ebb” in the general illiquidity of late has allowed for a balancing or retracement.

ABOOK March 2015 Ebb 10s5s Nominal

Nominal yields are now back where they were just prior to the kickoff of the last even in late November. But while nominal levels have backed up, the curve itself has remained flattened almost perfectly (eerily low volatility in the tangents) regardless of these violent nominal swings up and down.

ABOOK March 2015 Ebb 5s10sABOOK March 2015 Ebb 5s30sABOOK March 2015 Ebb 2s

About the only section of the curve to change has been the 2s30s, but, as you can see immediately above, that has been simply a reconvergence of the overshoot into the middle of January. So the overall curve flatness remains undisturbed by all of this, which I think is the most important fundamental indication. The backup in nominal rates across the treasury complex may be a belated reference to the FOMC’s position, one that treasury investors “had” to ignore in December and January because of the dramatic illiquidity positioning taking place at that time.

It seems that the funding curve, eurodollars, largely agrees as the curve there likewise ignored the threats to ZIRP and were enthralled instead in the illiquidity until somewhere between January 15 and 20.

ABOOK March 2015 Ebb EurodollarsABOOK March 2015 Ebb Swap Spreads

Since the beginning of February, the eurodollar curve has retraced back up to around where it was at the start of 2015. That leaves the curve still significantly short of its December 1 position when that last illiquidity move began.

ABOOK March 2015 Ebb Eurodollars Dec Comp

Putting all these variables together, it seems that fundamentally nothing much has changed as far as the credit market outlook for the economy short and long-term. Instead, the variable that has shifted is the liquidity event that ran its course around January 15 (the Swiss effect), thus “allowing” this pause in nominal terms. Like the weeks following October 15, these ebbs and flows exchange primary positions on reflecting nominal rates, but do not alter the curve flatness of the apparent governing dynamic.

In short, systemic liquidity remains dysfunctional including both directions in trading, and that is certainly playing a role in that governing dynamic which is a reset of perceptions of volatility in funding and beyond.