Treasury illiquidity and price of asymmetric information

There has been growing talk about the potential for Treasury illiquidity. Studies have focused on the micro dynamics of the markets and flash crashes, but liquidity will be driven in these macro markets by the distribution and use of information. Liquidity will ultimately be an information problem between those that have it relative to others who do not, the form of new information, and how new  information changes expectations. Information reaction and cascades will be the real driver of liquidity problems and these are hard to measure. Information shocks may not explain the flash crashes, but it will be the driver of the real liquidity threat which will be associated with large changes in market expectations and herding behavior.

Market liquidity is generated through two-sided markets with depth on both sides. Large orders will not disrupt prices because there is enough differences of opinion to take the other side of a trade. Consequently, there have to be a large number of traders who have heterogeneous expectations. If the market becomes more concentrated into the hands of fewer dealers or fewer large traders, there will be a greater likelihood for a liquidity events. Difference of opinion are critical because if there is similarity in opinion and the drivers of those opinions, there is more likely to be information events or shocks that will be one sided. Similarly if there are large players in the market, it may cause smaller players to follow the larger trader's behavior and cause information cascades. There will be herding if threes the belief that one side has a information advantage and the only rational approach is to follow market action.

Liquidity may become a significant problem if there is a general belief that the Fed will be raising rates. If the market believes that Fed policy and forward guidance through their words and actions will be credible and continual, the market will become one-sided and create a liquidity shortage. This should be a real fear in the next month. Of course, this is a an extreme. There usually will be enough differences of opinion about the intensity and timing of the rate increases which will make for two-sided markets; however, it is good to explore what could be the causes of liquidity shortages and agreement about what the Fed will do or not do is good place to start thinking about one-sidedness and liquidity. Illiquidity will be the price of asymmetric information and expectations.