Positive feedback trading in the US Treasurey market

Government bonds are at the heart of the global financial system. Because they usually represent the most creditworthy obligations in the economy, they are commonly used as benchmarks for pricing other obligations, as vehicles for hedging against changes in broad levels of interest rates, and as collateral for credit exposures. In recent years, other instruments have also begun to perform some of these functions. For example, interest rate swap yields have become pricing benchmarks in many fixed income markets, and exchangetraded derivatives such as futures and options have steadily gained importance as hedging vehicles.2 Nevertheless, government bond markets continue to play a central role in virtually all of the major economies. Any disruption to the trading or pricing of government bonds, such as happened at certain points during the market turbulence that followed Russia’s default in August 1998, has the potential to spread rapidly and to disrupt market functioning throughout the financial system (CGFS (1999, 2001) and Borio (2000)). The use of government securities as hedging vehicles means that price movements in related markets, such as those for bond options or mortgage-backed securities, can sometimes cause unexpectedly sharp movements in cash bond prices as well. Research on these dynamics has been limited; two recent examples are Kambhu and Mosser (2001) and Fernald et al (1994). Despite the systemic importance of government bond markets, relatively little is known about how price discovery takes place in these markets. This note examines one aspect of the price discovery process in the US Treasury bond market, namely the short-term interactions between market prices and new buy and sell orders. Confirming the results found by other researchers, we find that trades have a strong impact on prices, and that this impact is stronger on days when trading is relatively rapid and volatile than it is on quieter days. However, we also find that traders tend to reinforce price movements by buying when prices rise and selling when they fall, at least in the very short run. Moreover, this tendency is somewhat stronger in more volatile trading conditions.3 This second result is familiar to market practitioners, but has not yet been conclusively documented in the scholarly literature. A concluding section discusses some of the implications of this result for market functioning.