Price Formation and Liquidity in the U.S. Treasury Market: The Response to Public Information

The arrival of public information in the U.S. Treasury market sets off a two-stage adjustment process for prices, trading volume, and bid-ask spreads. In a brief first stage, the release of a major macroeconomic announcement induces a sharp and nearly instantaneous price change with a reduction in trading volume, demonstrating that price reactions to public information do not require trading. The spread widens dramatically at announcement, evidently driven by inventory control concerns. In a prolonged second stage, trading volume surges, price volatility persists, and spreads remain moderately wide as investors trade to reconcile residual differences in their private views. How DO FINANCIAL MARKETS FORM PRICES and provide liquidity when information arrives? Efforts to address this issue have led to an extensive microstructure literature on equity markets, and to a lesser extent on the foreign exchange (FX) market. Relatively little work has focused on the U.S. Treasury market, however, in spite of its importance in its own right and the advantages it offers as an alternative testing ground for microstructure hypotheses.