Editor’s note: Since this article was first published, a reference in the second paragraph to primary traders switching positions has been corrected to read “a net short position to a net long position”. February 6, 10:45 a.m.
The US Treasury market is one of the most liquid financial markets in the world, and Treasuries have long been considered a safe haven for global investors. Treasuries are often thought to achieve a “convenience yield”, in that investors are willing to accept a lower return than other investments with the same cash flow due to security and liquidity. treasury bonds. However, since the Global Financial Crisis (GFC), long-dated US Treasury bonds have traded at a consistent yield above the interest rate swap rate of the same maturity. The emergence of the “negative swap spread” seems to suggest that Treasuries are “troublesome”, at least relative to interest rate swaps. This article dives into this Treasury “inconvenience” premium and highlights the role of dealer balance sheet constraints in explaining it.
Cash position of primary dealers, negative swap spread and cross-currency basis
As in our recent Staff Report, we start with a striking chart showing a strong correlation between the net treasury position of primary traders and the swap spread (see chart below). Prior to the GFC, when dealers overall had a net short position in Treasuries, the swap spread was positive. The sign reversal in the swap spread coincides with primary traders moving from a net short position to a net long position in Treasuries. With this shift in dealer positioning, dealers continued to earn a positive spread on their Treasury positions hedged using interest rate swaps. In addition, post-GFC, the larger the dealers’ net position, the more negative the swap spread, or the more “troublesome” the Treasury bills.
Swap spread, CIP deviations and primary dealers’ net holdings of Treasuries are highly correlated
Notes: The chart shows the spread between the 30-year LIBOR-linked interest rate swap and the US Treasury yield (in blue), the 5-year US dollar-euro exchange basis (in red) and the net amount of primary traders. holdings of coupon treasury bills (in gold). The quote on the currency swap effectively measures the direct dollar interest rate minus the synthetic dollar interest by swapping the euro interest rate into dollars (Du, Tepper, and Verdelhan 2018b).
For dealers, the main difference between holding a treasury bill and holding an interest rate swap is that the treasury bill remains on the dealer’s balance sheet, but the swap is off-balance sheet. The tightening of the post-GFC risk-weighted leverage ratio constraint makes a large balance sheet costly for banks, even if the underlying positions are low risk.
The close correlation between swap spreads and cross-currency basis (the red line) post-GFC, also shown in the chart above, further supports the claim that interim balance sheet capacity is a key driver of growth. treasury swap spread. The cross-currency basis measures deviations from the covered interest parity (CIP) condition, a classic no-arbitrage condition. CIP deviations reflect the shadow cost of the interim balance sheet constraint (as discussed in this article and this article). In particular, a larger primary trader treasury position corresponds to a tighter balance sheet constraint and, therefore, a more negative swap spread and currency basis.
The role of the slope of the yield curve
What drives primary traders’ treasury position after the GFC when traders are long in treasuries? As shown in the following graph, the Treasury position of the primary dealers is strongly correlated to the slope of the yield curve: the dealers increase their Treasury position when the yield curve is flatter. The reason for this relationship is that as the Treasury yield curve flattens or inverts – a recurring feature of the monetary policy tightening cycle – real money investors (such as mutual funds and foreign insurers who hedge their currency risk to dollars using short-term forward contracts) are reducing their demand for Treasury bonds due to lower expected yields on those bonds. As a result, dealers (or leveraged investors who rely on dealer balance sheets) still need to increase their holdings of Treasuries, which tightens dealer balance sheet constraints, resulting in a more negative swap spread (and higher profits for dealers who go long in Treasuries covered by interest rate swaps).
Primary Dealer Term Spreads and Treasury Securities
Notes: The graph represents the yield spread between the ten-year Treasury bill and the three-month Treasury bill (in blue), and the net holdings of primary traders in Treasury bills (in red).
Set up a term structure model
In the paper, we construct a cohesive framework featuring constrained dealers, leveraged investors funded by dealer balance sheets, and yield-seeking real-money investors to explain these new facts. Whether brokers are net long or net short in Treasuries has a significant impact on returns. Using CIP spreads as a proxy for dealer balance sheet costs, our term structure model shows that the Treasury yield curve shifted from the dealer-net-short curve to the dealer-net-long curve, consistent with the change of the position of the dealers. (see table below).
Implied and real Treasury yields from the model (10-year maturity)
Notes: The chart shows the model’s implied net-long and net-short curves for Treasury securities, as well as actual Treasury yields. Data is from 2003-21. All returns are par returns.
Implications for policy
Finally, we use our framework to discuss the implications of several monetary and regulatory policies for the Treasury market, including quantitative easing and tightening, central bank swap lines, and the exemption of Treasury securities from the calculation of the additional leverage ratio. In particular, during a monetary policy tightening cycle, our model suggests that yield curve inversion and Federal Reserve balance sheet liquidation are likely to create significant pressure on financial intermediaries to absorb treasury bills. As a result, the expected accumulation of intermediate positions could lead to weakness in the Treasury market. On the other hand, we have extracted from our framework two recent developments that could make the current tightening cycle different. First, the large amount of liquidity accumulated in the overnight reverse repo facility can help absorb treasury bills and ease intermediate balance sheet stresses. Second, greater interest rate volatility may discourage dealer inventory accumulation and leveraged investor position due to additional value-at-risk type constraints, which were extracted from our framework. Overall, primary dealer treasury bill inventories and various intermediation spreads should be watched closely by policymakers and market participants.
Wenxin Du is a Financial Research Advisor in Capital Markets Studies in the Research and Statistics Group at the Federal Reserve Bank of New York.
Benjamin Hébert is an associate professor of finance at the Stanford University Graduate School of Business.
Wenhao Li is an assistant professor of finance and business economics at the Marshall School of Business at the University of Southern California.
How to cite this article:
Wenxin Du, Benjamin Hébert, and Wenhao Li, “Understanding the “Downsides” of U.S. Treasuries,” Federal Reserve Bank of New York Economy of Liberty StreetFebruary 6, 2023, https://libertystreeteconomics.newyorkfed.org/2023/02/understanding-the-inconvenience-of-us-treasury-bonds/.
Disclaimer
The opinions expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
