Monetary Policy & Inflation | Rates | US
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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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.
That said, we have seen a number of episodes, albeit as brief dislocations, where even USTs have experienced forces that impact their overall market functioning. As documented in this report post occurrence, in mid-October 2014 the UST market experienced very unusually high intraday volatility and quick moves in prices/yields. It was called a ‘flash crash’ to lower rates before calm returned to the markets. The concern in the 2014 event was that high frequency trading ‘algos’ exacerbated the moves in US rates; however, upon review it was hard to pinpoint what triggered the flash crash.
Fast forward to last year in mid-September: we all quickly found out that liquidity was also tied to the proper functioning of the repo financing market. As the ownership structure of the UST market shifted more towards domestic accounts and leveraged entities, the stability of the repo market became even more important than it usually is. The repo rate spike in 2019 was attributed to a variety of reasons, ranging from the aftershocks of less reserves in the system post quantitative tightening (QT) to large debt issuance to fund the Treasury general account (TGA). However, as this paper from NBER looks into, the impact of dealer balance-sheet (B/S) on market function also played a role as Treasuries piled up in the system.
Recapping March 2020 From the Treasury Market Point of View
With US yields now having settled into a broad range (which has been slanting downward of late given concerns about the recovery and potential for new Fed policies like NIRP and/or YCC), it would be easy to forget the intense movements experienced in the US Treasury market in early-to-mid March 2020. After briefly having gone under 40 basis points in all-in yield, the US Treasury 10-year interest rate vaulted higher to over 3x the low print to 1.2% all in a matter of a week or so. Here is where the concerns begin.
Figure 1: Treasury Yields and VIX During the COVID-19 Crisis
Source: Page 2 of “Treasury Inconvenience Yields during the COVID-19 Crisis”
As mentioned in the paper, the events of March 2020 did not follow prior crisis periods where Treasuries would traditionally catch a bid and then the flight-to-quality price action would keep all US rates lower than normal until calm returned in the broader financial markets. Instead, as seen in Figure 1, long-term USTs (CMT:10yr) broke ranks from short-term USTs (CMT:3m) and actually tracked the spike higher in equity vol. (as seen by the VIX).
NBER Paper Quote 1: ‘The only major episode with pro-cyclical bond prices (or, counter-cyclical real interest rates) was the Volcker disinflation of the early 1980s where the rise of real interest rates in a recession was induced by contractionary monetary policy intended to crush inflation. This is clearly not what happened in March 2020.’
Supply/Demand Does Matter When Up Against Limited Balance Sheets
As we come to find out, as seen from public sources such as the Fed’s H.4.1 and Treasury TIC data, foreign investors (Figure 2 left) sold hundreds of billions worth of legacy USTs (both on and off-the-run UST securities, a distinction worth making given that even within this market liquidity isn’t equal). In addition, the US government produced many new USTs to begin funding the fiscal response to COVID-19 as well. A lot of this extra supply ended up back on broker-dealer balance sheets or went indirectly through repo financing (Figure 2 right) that was extended to levered investors. It was the Fed’s herculean efforts that helped create space back on the private sectors’ B/S once they started to buy record amounts of USTs.
Figure 2: Foreign Investors Activity in USTs vs Dealer’s Total Repo
Source: Page 10 of “Treasury Inconvenience Yields during the COVID-19 Crisis”
Setting Up the Model to Study Negative Demand Shock Costs
As stated, the authors built upon the preferred habitat model by Vayanos and Vila and Greenwood and Vayanos to understand how a negative demand shock for long-term USTs can affect the term structure of USTs.
NBER Paper Quote 2: ‘In the preferred habitat model, dealers intermediate the exogenous demands of habitat investors. Since repo financing was an important part of dealers’ intermediation activities in March 2020, we extend this model to allow levered investors (hedge funds) to take positions in Treasuries financed by borrowing from dealers in the repo market.
Since repo financing was an important part of dealers’ intermediation activities in March 2020, we extend this model to allow levered investors (hedge funds) to take positions in Treasuries financed by borrowing from dealers in the repo market.
Moreover, dealers are subject to a balance sheet constraint, consistent with the supplementary leverage ratio (SLR) that dealers are subject to following the reforms adopted after the 2007-09 financial crisis. Importantly, both direct holdings of Treasuries and reverse repo positions that finance levered investments by hedge funds take up balance sheet space’.
This longer quote is important because it lays out why there are frictions in the marketplace even for Treasuries that are related to the level of repo funding costs, the risk of reduced collateral values, and higher yields later – not to mention the new financial regulations that add another layer of costs. Broker-dealers will offset these costs to their balance-sheets via requiring a higher yield (lower price for the securities) or higher repo funding rates.
So, in the model, the increase in long-term USTs had two components. There was higher-risk premium in USTs because dealers wanted compensation for taking on interest rate duration risk and a second piece, which the authors call ‘inconvenience yield’, that was a function of balance-sheet costs, that came about due to the SLR constraint. In order for the authors to pinpoint this second component they used USTs yields versus rates captured from matched-maturity overnight index swaps (OIS).
Model Results Show That B/S Friction Costs Can Drive Up US Yields
Through a series of complex formulas and interpretations, the authors find a connection between the supply shock and subsequent dealers’ B/S expansion (due to market making activities as well as offering reverse repo which also uses up B/S) with the rise in US yields during March 2020. They specifically find that as hedge funds (via repo) and dealers (via building inventory) acquire large sums of USTs, equilibrium yields go up (Figure 3).
Figure 3: Yield Curves, Repo Spreads, and Treasury-OIS Spreads
Source: Page 30 of “Treasury Inconvenience Yields during the COVID-19 Crisis”
Conclusion
This report provides both quantitative and qualitative explanations of why long-term UST yields became dislocated for a number of days in March 2020. Their model took a unique approach by introducing repo financing costs, which is an important factor that also drives dealer market making. In many ways, the experience in March 2020 was an extension of what has been plaguing the bond market ever since the September repo flare-up.
In a world of high debt loads, there is only so much private sector balance sheet, especially during periods where large-scale positions change hands. This, coupled with the UST market becoming increasingly more domestic (as foreign investors are buying less of the expanding stock of US debt), can become a reoccurring phenomenon which may change how the Fed interacts with the bond market, all in the spirit of market functioning.
NBER Paper Quote 3: ‘In summary, the observed movements in Treasury yields and spreads in March 2020 can be rationalized as a consequence of selling pressure that originated from large holders of Treasuries interacted with intermediation frictions, including regulatory constraints such as the SLR.
Evidently, the current institutional environment in the Treasury market is such that it cannot absorb large selling pressure without substantial price dislocations or intervention by the Federal Reserve as the market maker of last resort. Indeed, the Fed announced that it would directly purchase Treasuries to support the smooth functioning of markets.”
To view the full paper, please click here
George is a twenty years fixed income veteran. Over that time he has been an active participant on the research and investment side covering rates, structured products and credit. He worked both on the buy-side and sell-side. He can be reached here.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)