Where has all the liquidity gone?

The malfunctioning of the government bond market in a developed economy is an early warning of potential financial instability. In the UK, the new government’s proposed “mini-budget” raised the spectre of unsustainable sovereign debt and led to a dramatic widening in long-term gilt yields. Recognising the systemic importance of the government bond market, the Bank of England (BOE) correctly stepped in, both pausing its plan to unload gilts from its balance sheet and announcing that it will buy gilts over a fortnight at a scale near that of its planned sales for the next 12 months.

Markets have since calmed down. But as commendable as the BOE’s prompt response has been, we must ask what blame central banks bear for financial markets’ current fragility. After all, while long-term gilt yields have stabilised, gilt market liquidity (judging by bid-ask spreads) has not improved. And across the Atlantic, the market for US Treasuries is also raising liquidity concerns. Many metrics are flashing red, just like at the onset of the Covid-19 pandemic in 2020 and in the aftermath of Lehman Brothers’ failure in 2008.