What's behind the liquidity spread? On-the-run and off-the-run US Treasuries in autumn 1998

Autumn 1998 witnessed the Russian sovereign default and the near collapse of the hedge fund Long-Term Capital Management. These two events were part of a generalised flight to liquidity that affected markets worldwide. In an indepth analysis of the unique market events of that time, the Johnson Report identified ways in which market strains were exacerbated during the period.2 In particular, various yield spreads widened, including spreads between off-therun and on-the-run Treasuries. Although movements in the so-called liquidity spread have attracted much attention as a way to track shifts in market liquidity, there has been little careful analysis of the trading activity that lay behind the dramatic movements of 1998. In this special feature, we find that trading activity in off-the-run Treasuries actually increased during autumn 1998, a fact that would appear to contradict the evidence derived from liquidity spreads, which seemed to indicate reduced liquidity for these securities. We then examine trading activity more closely by focusing on only the most recently off-the-run security and by accounting for anticipated factors that affect trading, including the auction cycle, announcement events and days of the week. Once these factors are isolated, we do find evidence that there was a marked shift in trading away from the offthe- run issue. We then examine the impact of trades on price movements in both the on-the-run and first off-the-run five-year note. We find that the impact of trades on both securities became stronger during autumn 1998, an indication of reduced liquidity for both securities. The increase in the price impact, however, was more pronounced for the off-the-run note. During this period of stress, the impact of trades on the price of the off-the-run note strengthened tenfold while that on the on-the-run note only doubled.