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US Treasury keeps eye on bond market liquidity

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U.S. Treasury and Federal Reserve officials are monitoring the liquidity of bond markets after warnings from banks and institutional investors that the system has been weakened dangerously by new regulations.

According to people familiar with the matter, government officials are reviewing market data to assess whether there is any substance to financial industry arguments that rules designed to make markets more robust have had the opposite effect.

(Read more: US yields fall on perception of modest Fed tapering)

Investors and banks have delivered warnings – including in a July presentation to the Treasury – that new capital rules and the Volcker rule that prohibits proprietary trading at banks are sapping liquidity from the wider bond market, and that the negative effects have been masked by the Federal Reserve's unprecedented bond purchases under quantitative easing.

"Regulations have created multiple constraints likely to curtail liquidity when it is really needed," said a presentation from the Treasury Borrowing Advisory Committee, a group whose members range from JPMorgan to Pimco. It said there was a "potential for significant dislocation when investor flows reverse".

The Fed and Treasury are investigating but officials believe that liquidity was too cheap during the crisis and some change was desirable. They are also suspicious that the case – made by banks such as Citigroup and large institutional investors such as Fidelity – is overstated, with the drop in banks' inventories of corporate bonds skewed by the fact that the data include asset-backed securities.

Fed data show the inventories of corporate bonds held by big banks are down almost 80 percent since their peak of $235 billion in 2007. But Goldman Sachs analysts have estimated that the inventories are down 40 percent from their pre-crisis peak, once other assets are stripped out.

(Read more: Goldman's Hatzius: Fed will taper, but it will 'lean dovish')

However, there is some concern in Washington about the shock to bond markets that followed Ben Bernanke's comments in the spring that were seen as heralding the end of the Fed's quantitative easing program.

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"If the Fed starts tapering and the bond market sells off and people see their supposedly safe bond funds down, are they all going to start to sell them off? And where are they going to find liquidity?" said Stephen Siderow, co-founder of BlueMountain Capital.

(Read more: 'Bad idea' if Fed wages war on higher bond yields)

But officials monitoring bid-ask spreads say they have since returned to appropriate levels. They are not persuaded by the industry's point that lower inventories are a worrying factor for the next shock, since they believe lower inventories would not themselves prevent dealer banks buying bonds during such an event – just as in 2007 higher inventories did not mean banks were always happy to step in and buy in the falling market unless they saw a profitable opportunity.

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