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«Positive feedback trading in the US Treasury market1 Government bonds are at the heart of the global financial system. Because they usually represent ...»

Benjamin H Cohen Hyun Song Shin

+41 61 280 8921 +44 20 7955 7319

benjamin.cohen@bis.org h.s.shin@lse.ac.uk

Positive feedback trading in the US Treasury

market1

Government bonds are at the heart of the global financial system. Because

they usually represent the most creditworthy obligations in the economy, they

are commonly used as benchmarks for pricing other obligations, as vehicles for

hedging against changes in broad levels of interest rates, and as collateral for credit exposures. In recent years, other instruments have also begun to perform some of these functions. For example, interest rate swap yields have become pricing benchmarks in many fixed income markets, and exchangetraded derivatives such as futures and options have steadily gained importance as hedging vehicles. Nevertheless, government bond markets continue to play a central role in virtually all of the major economies.

Any disruption to the trading or pricing of government bonds, such as happened at certain points during the market turbulence that followed Russia’s default in August 1998, has the potential to spread rapidly and to disrupt market functioning throughout the financial system (CGFS (1999, 2001) and Borio (2000)). The use of government securities as hedging vehicles means that price movements in related markets, such as those for bond options or mortgage-backed securities, can sometimes cause unexpectedly sharp movements in cash bond prices as well. Research on these dynamics has been limited; two recent examples are Kambhu and Mosser (2001) and Fernald et al (1994).

Despite the systemic importance of government bond markets, relatively little is known about how price discovery takes place in these markets. This note examines one aspect of the price discovery process in the US Treasury bond market, namely the short-term interactions between market prices and new buy and sell orders. Confirming the results found by other researchers, we find that trades have a strong impact on prices, and that this impact is stronger on days when trading is relatively rapid and volatile than it is on quieter days.

However, we also find that traders tend to reinforce price movements by buying Hyun Song Shin is Professor of Finance at the London School of Economics. The views expressed in this article are those of the authors and do not necessarily reflect those of the BIS.

Wooldridge (2001), McCauley (2001) and BIS (2000 pp 116–18, 2001) look at shifts in the use of government bonds as benchmarks in fixed income markets.

BIS Quarterly Review, June 2002 when prices rise and selling when they fall, at least in the very short run.

Moreover, this tendency is somewhat stronger in more volatile trading conditions. This second result is familiar to market practitioners, but has not yet been conclusively documented in the scholarly literature. A concluding section discusses some of the implications of this result for market functioning.

–  –  –

A more detailed econometric analysis of trade-quote interactions in the US Treasury market, including how and why these patterns differ depending on market conditions, can be found in Cohen and Shin (forthcoming).

O’Hara (1995) surveys the academic literature on market microstructure. See CGFS (2000) for a discussion of policy issues related to market microstructure and bond market liquidity.

–  –  –

99.9 99.8 99.7 99.6

–  –  –

Sources: GovPX, Inc.; authors’ calculations.

Treasury prices along the entire yield curve. Around 12.30 pm, the Fed publicly denied that such a rescue was taking place. This led to an immediate and very steep drop in Treasury prices, followed by a mild recovery.

The trading atmosphere on 3 February 2000 was clearly one of great Order flows are not the whole story uncertainty. A view of market microstructure that emphasises the role of order flow in transmitting information would predict that the upward and downward movements in Treasury prices corresponded to greater order flow, with more buyer-initiated trades when the price rose and more seller-initiated trades when the price fell. This is confirmed by the 3 February data – up to a point (see table). There are more buys than sells during the period of the strongest upswing, from 11 am to 12.15 pm. Yet the imbalance between buys and sells is even greater from 2 pm to 5 pm, when prices rose by only a quarter as much.

Furthermore, when one examines these data in more detail, it proves hard to associate the turning points in the price series with specific clusters of buy and sell orders. It appears that, while the order flow hypothesis has some truth to it, there are also other factors at play.

Interactions between trades and prices To gain a broader understanding of these issues, we study trading activity in the on-the-run two-year note during normal trading hours (7 am to 5 pm) on all business days in the period from 4 January 1999 to 29 December 2000. This was an especially interesting period for the US Treasury market, because mounting fiscal surpluses had led to a decline in new issuance and, some observers claimed, a decline in liquidity in certain market segments. GovPX provides 358,361 ticks of data on the two-year note on the 501 business days during this period. Of this total, 40% represent trades without a change in quotes, 49% changes in the prevailing quote without any trade, and 11% trades accompanied by a change in the prevailing quote.





Analysing these data through econometric methods in Cohen and Shin (forthcoming), we find that not only does order flow cause price changes in the

–  –  –

0.000 0.25 0.000

-0.002 0 -0.001

-0.004 -0.25 -0.002

–  –  –

Sharp price declines averaged –0.0079%, while sharp price increases averaged +0.0080%;

for comparison, the standard deviation of price changes during a single tick was 0.0045% and the average absolute value of a price change was 0.0028%.

From these statistics and from Graph 2, one might think that there are simply more sells than buys on active days. In fact the net number of buys in an average 20-tick period is about the same on active days (0.42) as on quiet days (0.39); both see fewer net buys than normal days (0.64).

–  –  –

BIS Quarterly Review, June 2002 will be further selling – thus reinforcing the market’s price swing. The key area of market uncertainty in such cases is not the true valuation of the traded asset, but the mix of positions, strategies and constraints faced by market participants. Such uncertainty is likely to be greater at times when prices are moving quickly and traders are scrambling to adjust their positions.

Positive feedback and market functioning These results suggest that bond markets behave in meaningfully different ways depending on whether market conditions are calm or turbulent. This implies that analysts, market participants and market regulators cannot safely use the experience of calm times as a guide to how market prices will move or how effectively markets will function under specific stress scenarios.

To the extent that this is the case, it has implications for the assumptions Risk management should account for that underlie the ways in which government securities are used to hedge shifts in market against market and credit risk events. For example, the “haircut” that is applied functioning in turbulent times to the securities provided under a collateral agreement would need to be adjusted to account for the fact that markets are likely to be especially turbulent and one-sided at precisely those times when asset prices are moving sharply and more collateral may need to be provided or disposed of. Similar considerations would be relevant to the calculation of margin requirements for positions taken in organised derivatives exchanges.

A broader implication is that trading and risk management rules that may seem effective from the point of view of an individual trader can potentially have disruptive market-wide effects when put into practice by a significant fraction of market participants. Greater transparency about the strategies and assumptions that underlie the behaviour of important market participants can help to reduce these unintended effects, but a degree of uncertainty of this kind will always be present in some form in traded markets.

References Bank for International Settlements (2000): 70th Annual Report, Basel.

——— (2001): “The changing shape of fixed income markets: a collection of studies by central bank economists”, BIS Papers, no 5, October.

Borio, Claudio (2000): “Market liquidity and stress: selected issues and policy implications”, BIS Quarterly Review, November, pp 38–48.

Cohen, Benjamin H and Hyun Song Shin (forthcoming): “Positive feedback trading under stress: evidence from the US Treasury securities market”, in Risk measurement and systemic risk: proceedings of the third joint central bank research conference, Committee on the Global Financial System, Basel.

Genotte and Leland (1990) model how this might work in a market in which a significant number of actors follow portfolio insurance strategies.

–  –  –

——— (2000): Market liquidity: research findings and selected policy implications, Basel, March.

——— (2001): Collateral in wholesale financial markets: recent trends, risk management and market dynamics, Basel, March.

Evans, Martin D D and Richard K Lyons (2002): “Order flow and exchange rate dynamics”, Journal of Political Economy, vol 110, no 1, February, pp 170–80.

Fernald, Julia, Frank Keane and Patricia Mosser (1994): “Mortgage security hedging and the yield curve”, Federal Reserve Bank of New York Quarterly Review, vol 19, no 2, pp 92–100.

Fleming, Michael (2001): “Measuring treasury market liquidity”, Federal Reserve Bank of New York Staff Reports, no 133, July.

Fleming, Michael and Eli Remolona (1999): “Price formation and liquidity in the US Treasury market: the response to public information”, Journal of Finance, vol 54, pp 1901–15.

Gennotte, Gerald and Hayne Leland (1990): “Market liquidity, hedging and crashes”, American Economic Review, vol 80, pp 999–1021.

Glosten, Lawrence R and Paul Milgrom (1985): “Bid, ask and transaction prices in a specialist market with heterogeneously informed agents”, Journal of Financial Economics, vol 14, pp 71–100.

Hasbrouck, Joel (1991): “Measuring the information content of stock trades”, Journal of Finance, vol 46, pp 179–207.

Kambhu, John and Patricia Mosser (2001): “The effect of interest-rate hedging on the yield curve”, Federal Reserve Bank of New York Economic Policy Review, vol 7, no 3, pp 51–70.

Kyle, Albert (1985): “Continuous auctions and insider trading”, Econometrica, vol 53, pp 1315–35.

McCauley, Robert N (2001): “Benchmark tipping in the money and bond markets”, BIS Quarterly Review, March, pp 39–45.

O’Hara, Maureen (1995): Market Microstructure Theory, Blackwell Publishers, Cambridge, MA.

Wooldridge, Philip (2001): “The emergence of new benchmark yield curves”, BIS Quarterly Review, December, pp 48–57.

BIS Quarterly Review, June 2002





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