The Fed's moves to address liquidity issues in the Treasury market appear to be having the intended effect -- but pockets of concern remain.
In mid-March, the Treasury market went through a period of severe illiquidity. As we discussed in a recent webcast on the Fed’s role, illiquidity in the Treasury market was apparent in a number of ways: the elevated cost of transacting in Treasury bonds, the large difference in yields between on-the-run and off-the-run Treasury bonds, the very high day-to-day volatility in Treasuries, and the breakdown of normal correlations between Treasuries and other assets.
The bigger picture behind these dislocations was that the investors had been selling Treasuries to raise cash in their portfolios. The demand for cash was fueled by pervasive concerns about the macroeconomic outlook—obviously due to the COVID-19 pandemic but also the oil price rout—and a deep uncertainty about the implications for financial assets. Investors’ preference for cash over other financial assets is common in such environments. This time the demand for cash was system-wide, in that it affected investors across the globe and across asset classes, which in turn led to a truly astounding amount of Treasury sales. Why were investors selling Treasuries to raise cash? The simple answer is that investors tend to sell what they can to raise cash, which is often Treasuries because of the relative depth of that market.
As investors were selling Treasuries, dealers were forced to take the other side and become buyers of Treasuries. This resulted in a substantial amount of Treasuries building up on dealer balance sheets. In normal times this wouldn’t necessarily cause a problem, as dealers can use derivatives to hedge the risk related to holding Treasuries. That was not possible, however, because the illiquidity had affected the derivatives market, which was also experiencing distorted prices and very elevated volatility. Together with concerns about regulatory leverage ratios, the inability of dealers to hedge any further purchases contributed to exceptionally thin markets and the overall market illiquidity.
This centrality of US Treasuries to other markets and strategies makes illiquidity in the Treasury market particularly problematic. For example, many investors buy corporate bonds to capture the spread between corporates and US Treasuries. Any investment in this strategy requires buying corporates and simultaneously selling Treasury bonds. If the Treasury market doesn’t function, these types of strategies are no longer available, which in turn reduces participation in corporate markets.
This was the environment in the middle of March: large-scale cash raising led investors to sell Treasuries, which then accumulated on dealer balance sheets, which in turn became overwhelmed, causing further illiquidity in Treasury markets. Finally, because of the centrality of Treasuries to other markets, the illiquidity in Treasuries contributed to the distortions across risk markets as well.
Over the last two weeks the Fed has addressed this problem through a very aggressive and unprecedented amount of Treasury bond purchases, as well as agency MBS purchases. The program was initially announced as $700 billion of purchases, but merely a week later was expanded to purchases “as needed” to support market liquidity. Over the past week and a half the Fed has been purchasing $75 billion of Treasury securities on a daily basis. At this pace it will take less than two full weeks for the Fed to purchase more securities than it did during the entire QE2 program, which took over eight months to implement.
The Fed’s purpose in conducting such a massive purchase program is to provide cash to the end investors who are demanding it. Due to operating constraints, the Fed has to do this by buying Treasury bonds from dealers in exchange for cash, and the dealers in turn provide cash to investors in exchange for their Treasury bonds. It’s somewhat circuitous, but the Fed’s purchases do work and should, over time, both meet the financial system’s demand for cash and in doing so stabilize the Treasury market.
Our assessment is that the Fed programs are showing early signs of having the intended effect. In particular, the Treasury market is already starting to see some modest stabilization. However, while some markets have moved away from the extreme levels of a few weeks ago, there remain pockets of concern. One such area of concern continues to be the market for unsecured financing. The following charts provide visual evidence of the stabilization in the Treasury market, as well as the area that appears to be lagging.
Beginnings of Stabilization
The beginnings of stabilization in the Treasury market are encouraging. The Fed deserves credit for its central role in bringing this about. While the nature of the Fed’s response is classic central banking—providing liquidity in times of panic—the speed and scale of the response is notable. Finally, given the centrality of Treasury bonds to many different investment strategies, it is possible that the stabilization of the Treasury market can contribute to the healing process for other dislocated markets as well.
Exhibit 1: Federal Reserve Daily Purchases
Source: New York Federal Reserve. As of 30 Mar 20. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
On Monday, March 23, the Fed announced that its purchases would be “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.” Since then the Fed has been purchasing approximately $75 billion in Treasury notes and bonds and approximately $50 billion in agency MBS every day. Note that some of the agency MBS purchases have been replacing bonds that have pre-paid, so the net expansion of MBS on the Fed’s balance sheet has been somewhat smaller than the purchases alone would suggest. The language “in the amounts needed” underscores that there is no limit to the Fed’s purchases, meaning that purchases can continue at this pace for as long as necessary.
Exhibit 2: Primary Dealer Holdings of Longer-Term US Treasuries (>11 years)
Source: New York Federal Reserve. As of 18 Mar 20. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Recently primary dealers have accumulated large amounts of US Treasury securities as investors have been selling them to raise cash. These have become increasingly difficult for dealers to hedge, given dislocations in derivatives markets. Note that this data is released with a small lag, and is currently only available through March 18. Given the substantial Fed purchases, we expect the next release will show lower holdings in longer-term Treasuries.
Exhibit 3: Triple Old 10-Year Treasury Yield vs. Current 10-year Treasury Yield
Source: JP Morgan. As of 30 Mar 20. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The difference between the yields of off-the-run and on-the-run Treasury securities is an indicator of the market’s capacity to bear risk, and in particular its capacity to bear risk in cash Treasury bonds. In normal times, there should be very little yield difference between the two bonds—they have the same structure, similar maturity and same underlying credit. However, in times of stress, especially when there is limited ability to hold cash securities, the difference can increase. The “Triple Old 10-year Treasury” is the 10-year Treasury bond that was issued three quarterly auction cycles previously. For example, right now the Triple Old 10-year Treasury is the Treasury bond that was issued in May of 2019.
Exhibit 4: Treasury Volatility—The MOVE Index
Source: Bloomberg. As of 30 Mar 20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The MOVE Index is an indicator of implied volatility in the Treasury market. The MOVE Index is often described as being similar to the more familiar VIX Index, which is the implied volatility in the equities market. The MOVE Index is a weighted average of volatility in 2-, 5-, 10- and 30-year Treasury yields, with slightly more weight placed on the 10-year.
Exhibit 5: 3-Month LIBOR vs. 3-Month T-Bills
Source: Bloomberg. As of 30 Mar 20. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
3-month LIBOR is the estimated cost for unsecured borrowing for a major bank. 3-month T-Bill yields are simply the yield on short-term US Treasury Bills. In normal times, banks borrow at a modestly higher rate than the US government does, due to the additional credit risk. The rate at which banks borrow can rise much higher in stressed times, however, due to a combination of heightened credit risk as well as dynamics in money market funds. Recently large outflows from prime money market funds, which led to concerns about prime funds hitting regulatory limits that may require gates, have led to a pull back from investments in commercial paper, which has in turn pressured bank borrowing costs higher. This is one area of the market that remains stressed.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
U.S. Treasury Inflation Protected Securities (“TIPS”) are bonds that receive a fixed, stated rate of return, But they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk.
A floating rate note (FRN) is a bond that has a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread, which remains constant.
An on-the-run security or contract is the most recently issued of a periodically issued security. On the run securities are generally more liquid and trade at a premium to other securities.
An off-the-run security is older than the most recent issue of a periodically issued security and trade at a discount to on the run securities.
Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.
COVID-19 is the World Health Organization's official designation of the current coronavirus disease.
Regulatory leverage ratio refers to the leverage, i.e., the amount of borrowing or lending relative to the amount of assets, that is required by the regulations governing banks and other financial institutions.
A spread is the difference in yield between two different types of fixed income securities with similar but not identical characteristics, with the possible differences including creditworthiness, maturity date, or other factors.
Agency mortgage-backed securities (MBS) are asset-backed securities secured by a mortgage or collection of mortgages issued by federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae.
QE2 refers to the Federal Reserve’s second round of quantitative easing, announced in November 2010, whereby the Fed would buy $600 billion of Treasury securities by the end of the second quarter of 2011. In August 2010, Fed Chairman Ben Bernanke pre-announced QE2 at the annual economic policy symposium in Jackson Hole, Wyoming.
Unsecured financing refers to loans which are not backed by collateral such as mortgages, bonds, or other assets.
A primary dealer is a bank or other financial institution that has been approved to trade securities with a national government. For example, a primary dealer may underwrite new government debt and act as a market maker for the U.S. Federal Reserve. Primary government securities dealers must meet specific liquidity and quality requirements. They also provide a valuable flow of information to central banks about the state of worldwide markets.
“Triple Old 10-year Treasury” is the 10-year Treasury bond that was issued three quarterly auction cycles previously. For example, as of April 1, 2020, the Triple Old 10-year Treasury is the Treasury bond that was issued in May of 2019.
A prime money market fund (MMF) invests in floating-rate debt and commercial paper of non-Treasury assets, like those issued by corporations, U.S. government agencies, and government-sponsored enterprises (GSEs).
The ICE BofA MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30. (weighted average of 1m2y, 1m5y, 1m10y and 1m30y Treasury implied vols with weights 0.2/0.2/0.4/0.2, respectively).
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.
A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less. Treasury bills are usually sold in denominations of $1,000. However, some can reach a maximum denomination of $5 million in non-competitive bids. T-Bills are available in a variety of maturities, including 1 month and 3 months.
The London Interbank Offered Rate (LIBOR) is the interest rate determined daily by a specific group of London banks for deposits of certain stated maturities. LIBOR is used as a base index for setting rates of some adjustable rate financial instruments, including Adjustable Rate Mortgages (ARMs).
Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts payable and inventories and meeting short-term liabilities. Maturities on commercial paper rarely range longer than 270 days.