December 3, 2018 / 3:43 PM / 10 days ago

Inexplicable spikes still imperil Treasury market: Fed's Brainard

NEW YORK (Reuters) - Four years after the so-called “flash rally” spooked U.S. investors and regulators, the Federal Reserve remains concerned that the U.S. Treasury market still occasionally moves sharply without any apparent reason, a top Fed official said on Monday.

Federal Reserve Board Governor Lael Brainard speaks at the John F. Kennedy School of Government at Harvard University in Cambridge, Massachusetts, U.S., March 1, 2017. REUTERS/Brian Snyder

Those concerns persist as the Fed has begun collecting and analyzing data which showed the impact of the growth of propriety trading firms and high-frequency trading in the $15 trillion Treasury market.

“Markets have been able to weather several episodes of short-lived market turbulence well in the past few years,” Fed Governor Lael Brainard said in prepared remarks.

“But the fact that sharp market movements...can occur even in the absence of clear news drivers remains a concern and highlights the potential risks to financial stability posed by the high-speed transmission of price and liquidity shocks across multiple markets and trading venues,” she added.

For example, Brainard cited the turmoil in equity and bond markets on February 5. While trading volumes in both the electronic inter-dealer broker and dealer-to-client market segments were markedly above average, some measures of liquidity, such as market depth near the top of the order book on major electronic inter-dealer broker platforms, deteriorated and remained low through the week, she said.

This pattern of a jump in trading volumes followed by a persistent decline in market depth has been characteristic of three episodes of market turbulence: the Treasury flash rally over four years ago, the flash crash in sterling in October 2016 and the spike in the VIX index eight months ago, she said.

Brainard, addressing a market structure conference at the New York Fed, said a stable Treasury market is vital as the central bank continues to trim its bond portfolio with the U.S. economy “at or beyond” full employment and inflation “around target.”

In addition to understanding recent market turbulences, it is critical to analyze systematic intraday spikes in trading volumes in the ways they affect prices and liquidity in the Treasury market, Brainard said.

For example, the large spike in flows toward the end of the trading day points to a financial stability consideration that is worth flagging.

The Fed has not seen any large-scale sale of Treasuries at the end of the day to raise cash, based on collected data through the Trading Reporting and Compliance Engine (TRACE) system, Brainard said.

“It is not clear from the TRACE data whether the market could accommodate a large sale of Treasury securities later in the day,” she said.

Reporting by Jonathan Spicer and Richard Leong; Editing by Chizu Nomiyama

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