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By George Goncalves 15-07-2020

UST Liquidity: Safe-Haven Status At Risk Or A Sign Of B/S Constraints?

(7 min read)
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What is liquidity? In market parlance, it’s the idea that investors have the ability to quickly buy or sell an asset without resulting in a major deviation from prevailing prices. However, those that trade for a living know that the nature of market liquidity is an ever-evolving process which can change daily due to their being many variables that can enhance or detract from creating conditions that are conducive to deep, easy to transact, liquid markets. In addition to all of the private sector drivers (the interface of regulation, positioning, preferred habitat, etc.) over the last decade or so central banks have become larger players in their respective sovereign markets, for both monetary policy and market functioning purposes.
In this Deep Dive, we review an NBER paper, ‘Treasury Inconvenience Yields During the Covid-19 Crisis’, published by Zhiguo He, Stefan Nagel and Zhaogang Song from the University of Chicago Booth School of Business, NBER and The John Hopkins Carey Busines School. These researchers explore what potentially drove the Treasury market illiquidity witnessed during the early days of the Covid-19 crisis and have developed a model that analyses the impact of dealers’ balance-sheet constraints and supply/demand shocks on the term structure of UST yields.

Before We Get Into the Paper’s Findings, Here is Some Background

For decades, the one market that has always been viewed as the most liquid and deepest has been US Treasuries (USTs). The ties back to the dollar (the main FX reserve currency used for international trade) along with what is still the largest economy and global banking system (that uses USTs as collateral, hedging tools and as a point of reference as the ‘risk-free’ rate) have afforded USTs what most consider to be the highest level of liquidity.

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