When stock markets plunge, investors usually rush to buy US Treasurys, which have long been the world’s safe-haven asset. But during the COVID-19 stock crash in March and April, Treasury markets seized up and there seemed to be a lack of demand.
This ominous sign could have signaled a global shunning of US debt and a reshaping of the world economic order. Or it could have signaled rising inflationary expectations. But rather, it reflected a new form of market inefficiency introduced as a safety measure after the 2008–09 financial crisis, according to Chicago Booth’s Zhiguo He and Stefan Nagel and Johns Hopkins’s Zhaogang Song.
The role of US Treasury bonds as the world’s safe-haven asset has long benefited the US economy. It allows the US government to refinance debt easily, because global demand for Treasury bonds is robust and constant, particularly during tough economic times.
During the COVID-19 stock sell-off, however, a different pattern emerged. While there was plenty of demand for Treasurys, it was for shorter maturities, the researchers find. Inflation, including inflation uncertainty, didn’t seem to be a big worry, as there was no increase in demand for the Treasury Inflation-Protected Securities.
Large institutions and global central banks scrambled for immediate liquidity, shortening the duration of their holdings from Treasury notes, which are issued with terms of between two and 10 years, to Treasury bills, with maturities of less than a year.
Bond dealers facilitate liquidity for short-term Treasurys through repurchase agreements, known as repo transactions. In a repo, the dealer sells a short-term security while promising to buy it back at a slightly higher price in short order, often the next day. The selling institution—which could be a smaller dealer or a hedge fund—is the borrower in this transaction: it swaps a debt instrument for cash, and the premium it pays when it buys the debt back is akin to an interest payment. For the lender on the other side of the transaction—which could be some large primary dealer—it is called a reverse repo.
Generally, when a dealer borrows or lends, regulators require it to hold a certain amount of capital as protection in the event the borrowed instrument loses value. Until 2015, that didn’t apply to Treasurys because they were considered risk free.
In 2015, the Treasury imposed a new requirement to comply with the international Basel III standards, a global effort to strengthen the financial system following the economic crisis of the previous decade. Authorities imposed a new supplementary leverage ratio, known as rule SLR, for dealers involved in repo deals. They had to hold capital equal to 3–5 percent of their repo exposure.
This was no problem until the markets lurched into a sudden rotation from long- to short-term Treasurys in response to the COVID-19 crisis, the researchers find. In the first crisis test of the new regulation, the system simply seized up because of the new Basel III balance-sheet capital requirement, the research demonstrates.
“Both direct holdings of Treasurys and reverse repo positions of dealers are subject to a balance sheet constraint related to regulation reforms since the 2007–09 crisis such as the supplementary leverage ratio,” He, Nagel, and Song write.
Their research serves as a warning to regulators that the Fed needs to do all it can to ensure bond-market liquidity in times of stress. It also offers a hint of what markets might look like if the United States is displaced as the world’s global reserve, a potential reality if China succeeds in internationalizing its currency, which is a topic of much interest to He.
When the market seized up in early spring, the Office of the Comptroller of the Currency (a branch of the Treasury) and the Fed resolved the situation by temporarily suspending the SLR rule April 1, according to the researchers. Treasurys were again considered risk free, and bond markets have functioned normally ever since.
Zhiguo He, Stefan Nagel, and Zhaogang Song, “Treasury Inconvenience Yields during the COVID-19 Crisis,” NBER working paper, June 2020.
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