For example, quoted bid-ask spreads, after widening sharply during the financial crisis, subsequently narrowed and have remained stable at pre-crisis levels since 2010. (Exhibit 1) Other measures paint a more mixed picture. While order book depth is appreciably lower now than in 2012 and 2013, it is much higher than during the financial crisis, and does not appear to be unusually low by historical standards. (Exhibit 2) Similarly, the price impact of trades appears to have risen a bit since the October 15 flash rally indicating some deterioration of liquidity, but is still not high relative to its longer-run experience. (Exhibit 3) Average trade sizes have followed a similar pattern to the order book depth and have recently declined somewhat. (Exhibit 4) Another way to assess liquidity conditions is through the potential impact on Treasury yields. If liquidity had deteriorated markedly, then we would expect to see larger deviations of actual yields compared to the yields predicted by an empirically fitted yield curve. If liquidity were more costly, the deviations of actual yields from fitted yields would increase because the costs of arbitrage to eliminate those divergences would be higher. During the financial crisis, for example, there was a sharp deterioration in liquidity, which was associated with a sharp rise in some measures of yield curve fitting errors to a peak of about 20 basis points. This compares to less than 2 basis points prior to the crisis. In contrast, yield curve fitting errors have been low and stable recently and not outside historical norms.
(Exhibit 5) Of course, the Federal Reserve’s large scale interventions in the Treasury market over this period may also have had an impact on this measure. Turning to corporate bonds, given their heterogeneous nature, liquidity in the corporate bond market depends on the ability and willingness of dealers to hold these securities on their balance sheets while they find buyers. Disaggregated data on dealer balance sheet holdings have only been published since April 2013. While limited in terms of its history, these data indicate no clear reduction in investment grade security holdings over time, but do show a significant reduction in high-yield security holdings since the end of the financial crisis. This might be indicative of deterioration in market liquidity in corporate bonds. To investigate corporate bond market liquidity in more detail, let’s examine three liquidity measures: the average trade size, “effective” bid-ask spreads and price impact. The evidence on the average trade size for investment grade corporate bonds indicates a slight reduction from between $ to $ in the early 2000s to around $ in the last few years. (Exhibit 6) However, price measures of corporate bond liquidity do not substantiate the trend in this quantity measure. The effective bid-ask spread has been trending down since the early 2000s, around the same time that TRACE reporting was introduced. The spread spiked during the financial crisis, but is now lower than its pre-crisis levels.