Working Paper: NBER ID: w27416
Authors: Zhiguo He; Stefan Nagel; Zhaogang Song
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.
Keywords: Treasury Yields; COVID-19; Market Liquidity; Repo Market; Balance Sheet Constraints
JEL Codes: E4; E5; G01; G21; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| supply shocks (E39) | treasury inconvenience yields (E43) |
| dealer balance sheet constraints (G32) | treasury inconvenience yields (E43) |
| dealer balance sheet constraints (G32) | higher yields (Q15) |
| dealer balance sheet constraints (G32) | reverse repo rates (E43) |
| higher yields (Q15) | reduced demand for treasury bonds (E43) |
| selling pressure from large holders of treasuries (E43) | price impacts in the market (D41) |
| supply-demand interactions (J23) | treasury and repo market dislocations (E44) |