The Bond Market Has A Warning For You About Stocks

The chart above shows the bid-ask spreads of Treasury bonds across various maturities and how they’ve been trending over time. This spread represents the difference in the price that a market maker is willing to pay for an asset (the bid) and the price at which they’re willing to sell (the ask). The gap here, or spread, serves as the market maker’s compensation for providing liquidity to markets. So, the bigger the risk in making a market in a particular asset (for example, when it’s infrequently traded or when its price is highly volatile), the bigger the spread. From an investor’s perspective, then, the wider the bid-ask spread, the more costly it is to trade the asset.

Taken altogether, the bid-ask spread is the de facto measure of an asset’s liquidity – the ease with which the asset can be converted into cash with minimal costs and without affecting its market price.

Last week, bid-ask spreads on two-, ten-, and 30-year Treasuries jumped to their highest levels in at least six months, according to data compiled by Bloomberg. That comes after one of the wildest weeks for bond markets since at least 2008. Don’t just take my word for it: the Treasury market’s “fear gauge” – the Intercontinental Exchange’s (ICE) MOVE index of implied volatility – spiked to levels not seen since the start of the global financial crisis nearly 15 years ago.

It’s hard to say what’s causing what, and the two are likely affecting each other. That is, a volatile bond market elevates market makers’ risk and pushes them to increase their bid-ask spreads. Those wider spreads, in turn, lead to deteriorating liquidity, which exacerbates price swings and increases market volatility.

This loop of vanishing liquidity and increasing volatility matters because Treasuries are vitally important to the financial system: they’re not just the ultimate “risk-free” asset, they also act as collateral for loans and are used to price almost all financial instruments. It’s essential, then, that they remain well-behaved. So when volatility spikes in the Treasury market, it pushes investors and companies to take fewer risks and reduces the amount of money in the financial system available for investors to access. And that sends ripple effects across the economy and other asset classes.

As for what this all means for you: well, keep in mind that old Wall Street saying that the bond market is always smarter than the stock market. If that's true, then you may want to exercise some caution right now. That is, make sure your portfolio is well diversified, holds some cash, and doesn’t contain leverage. There may be volatile days ahead.