Dealer capacity tightened significantly in March – Fed research

The ability of US primary dealers to intermediate in the Treasuries market tightened significantly in March, while demand for liquidity soared, new research from the Federal Reserve finds.

Dealers’ balance sheet capacity, which economist Jonathan Goldberg calls “dealers’ liquidity supply”, contracted by $100 billion, or 17%, in March.

That is the fifth-largest percentage decline in liquidity supply since Goldberg’s underlying data began in 1990, and is roughly the same as that following the collapse of Long-Term Capital Management, an event that sent shockwaves throughout the financial system.

At the same time, investors’ liquidity demand “soared” in March by $120 billion, or 26%, he finds.

That is the largest percentage increase in liquidity demand since Goldberg’s data began. In comparison, following both the 9/11 attacks in 2001 and the collapse of Bear Stearns in 2008, liquidity demand increased by 15%, he says.

“A shortage of market liquidity in the Treasury market provides an important signal about liquidity in the broader universe of financial markets,” Goldberg notes.

For example, he says a tightening of dealer liquidity supply of the magnitude seen in March would historically be associated with a 20% increase in the cost of trading corporate bonds. 

It would also typically be associated with a decline in corporate bond issuance of 0.3% of GDP for 12 months ahead and a decline in shareholder payouts of 0.4% of GDP. Unemployment would also historically rise by 0.4 percentage points the following year, Goldberg says.