Treasury Inconvenience Yields During the Covid-19 Crisis

Abstract

In sharp contrast to most previous crisis episodes, the Treasury market experienced severe stress and illiquidity during the COVID-19 crisis, raising concerns that the safe-haven status of U.S. Treasuries may be eroding. We document large shifts in Treasury ownership and temporary accumulation of Treasury and reverse repo positions on dealer balance sheets during this period. We build a dynamic equilibrium asset pricing model in which dealers subject to regulatory balance sheet constraints intermediate demand/supply shocks from habitat agents and provide repo financing to levered investors. The model predicts that Treasury inconvenience yields, measured as the spread between Treasuries and overnight-index swap rates (OIS), as well as spreads between dealers' reverse repo and repo rates, should be highly positive during the COVID-19 crisis, which are confirmed in the data. The same model framework, adapted to the institutional setting in 2007-2009, also helps explain the negative Treasury-OIS spread observed during the Great Recession.

When Selling Becomes Viral: Disruptions in Debt Markets in the COVID-19 Crisis and the Fed’s Response

“…We focus mostly on spreads related to corporate bonds, in search of an explanation of what seem to be the largest abnormal price movements, in the pricing of investment-grade debt. Duffie (2020) , Fleming and Ruela (2020) , He, Nagel, and Song (2020) , and Schrimpf, Shin, and Sushko (2020) offer thorough studies of the Treasury bond market.…”

“…25 Furthermore, it is likely that intermediation opportunities in other disrupted markets were more profitable at that point. In particular, Duffie (2020) , He, Nagel, and Song (2020) , and Schrimpf, Shin, and Sushko (2020) discuss disruption in Treasury markets during the same period.…”

“…Naturally, all these intermediation costs only increase in periods of distress. In addition, corporate bond trades might have been crowded out by better opportunities in the also disrupted Treasury market (see Duffie 2020 and He, Nagel, and Song 2020 ). One manifestation of this lower willingness to intermediate is that the price that dealers charge for trading bonds rose during this period ( Kargar et al (2020) ).…”

“…Financial frictions appear to play a role in other markets as well during the crisis. Duffie (2020) , Fleming and Ruela (2020) , He, Nagel, and Song (2020) , and Schrimpf, Shin, and Sushko (2020) highlight issues in the Treasury market. Bahaj and Reis (2020) show CIP deviations in the current crisis and point to strain in dollar funding markets.…”

The Private Production of Safe Assets

“…Stein (2012) posits that privately issued safe assets may impose negative externalities on financial stability, which justifies the use of public asset supply as a policy tool. Recently, He, Krishnamurthy, and Milbradt (2019) propose a model of public safe asset determination based on the relative strength of an issuer's balance sheet, while in He, Nagel, and Song (2020) the demand for Treasuries and repos depends on dealers' balance sheet costs.…”