Declining liquidity in sovereign markets: Emerging fault lines

Liquidity, or the lack thereof, has become a major discussion topic in the bond market recently, with various prominent market participants highlighting its deterioration as a potential source of future market instability.

The various facets of liquidity in major sovereign bond markets and develop a framework to show how they are related to the cost for active traders to transact in the secondary markets. Liquidity premium is priced rationally in government bond yields and show that it has risen in US, Germany and UK and fallen in Italy and Spain over the last few years.

It is also expected that "herding" among institutional investors has increased over the past few years. This combination of greater herding and diminishing liquidity is a potent cocktail that heightens tail risks, according to Barclays.

Given that many of the post-crisis regulatory changes are here to stay, and with regulator buy-in for the changes in market structure thus far, the general trend towards lower liquidity in government bond markets is likely to persist. findings suggest that liquidity in cash government bonds, futures markets and repo markets are related and recommend that policy-makers view them holistically, noted Barclays.