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How Can Protected Asset Markets Be Fragile?

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The marketplace for U.S. Treasury securities skilled excessive stress in March 2020, when costs dropped precipitously (yields spiked) over a interval of about two weeks. This was extremely uncommon, as Treasury costs sometimes improve throughout occasions of stress. Utilizing a theoretical mannequin, we present that markets for secure property may be fragile as a consequence of strategic interactions amongst traders who maintain Treasury securities for his or her liquidity traits. Frightened about having to promote at doubtlessly worse costs sooner or later, such traders might promote preemptively, resulting in self-fulfilling “market runs” which might be much like conventional financial institution runs in some respects.

Value Crash with Constrained Supplier Steadiness Sheets and Unprecedented Gross sales

The bizarre occasions in Treasury markets in March 2020 have been mentioned extensively in earlier posts. We wish to draw consideration to a confluence of two parts: First, the supplier banks that present Treasury market liquidity confronted mounting challenges to their intermediation capability. The chart under exhibits that supplier steadiness sheet area allotted to Treasury securities elevated each through the run-up in Treasury costs and their subsequent crash. The restoration in Treasury costs after March 18 coincided with supplier steadiness sheet strain receding because the Federal Reserve’s Treasury purchases ramped up.

Sellers Have been Constrained via the Run-up and Crash of Treasury Costs

Line chart showing the market yield on U.S. Treasury securities at 10-year constant maturity (reverse scale), Federal Reserve outright holdings of Treasury notes and bonds (nominal and TIPS), and Primary Dealers’ net position and reverse repo in Treasuries (nominal and TIPS) between February 1 and May 1, 2020, in trillions of dollars.
Sources: FRED, Federal Reserve Financial institution of St. Louis; New York Fed Main Supplier Survey.
Notes: The chart exhibits the market yield on U.S. Treasury securities at 10-year fixed maturity (reverse scale), Federal Reserve outright holdings of Treasury notes and bonds (nominal and TIPS), and Main Sellers’ web place and reverse repo in Treasury securities (nominal and TIPS).

Second, the habits of international traders and mutual funds, the primary sellers of Treasury securities in March 2020, was very uncommon. The subsequent chart exhibits the web purchases of the 2 teams over time and highlights that their gross sales within the first quarter of 2020 have been unprecedented—a lot bigger than ever earlier than.

Unprecedented Gross sales that Seem Precautionary

A two-panel bar chart showing net purchases of all types of Treasuries in billions of dollars by foreign investors (left chart) and mutual funds (right chart) over time. Both sectors saw unprecedented Treasury sales in Q1 2020—much larger than ever before.
Supply: Board of Governors of the Federal Reserve System, Monetary Accounts of the USA, Desk FU.210.
Word: The chart exhibits web purchases of Treasury securities (every kind) for the 2 sectors with the most important gross sales in 2020:Q1. “International traders” refers back to the “remainder of the world” sector within the authentic desk.

Vissing-Jorgensen (2021) exhibits proof that each teams’ gross sales of Treasury securities exceeded their precise liquidity wants. The unprecedented magnitude of the gross sales, and the truth that a substantial fraction of them have been precautionary, makes this habits seem similar to a run—harking back to depositors speeding to withdraw funds from a financial institution. In step with this proof, the Inter-Company Working Group for Treasury Market Surveillance (2021) studies that “some Treasury holders appeared to react to the decline in market liquidity by promoting securities for precautionary causes lest circumstances worsen additional, and these gross sales solely added to the stress available on the market.”

Strategic Interplay amongst Treasury Traders Can Result in Fragility

In a current Employees Report, we examine theoretically how strategic interplay amongst traders could make markets fragile and result in “market runs.” We explicitly contemplate the chance that completely different traders worth secure property comparable to Treasury securities for completely different causes. Before everything, secure property are secure, that means they’re anticipated to pay their full par worth at maturity with close to whole certainty. In consequence, we sometimes observe “flight to security” throughout occasions of stress, by which demand for secure property will increase, pushing up their value. Second, secure property are liquid, and so some traders maintain secure property to promote them when confronted with sudden liquidity wants. Throughout occasions of stress, traders’ liquidity wants can improve, competing with the standard “flight to security” and exerting downward strain on the value of secure property after they make a “sprint for money.”

Our mannequin, which builds on Bernardo and Welch (2004), exhibits {that a} secure asset market is secure and well-functioning so long as the market is sufficiently deep. On this case, flight to security and sprint for money are complementary phenomena, with traders who purchase the property for security absorbing gross sales from traders who promote the property for liquidity. Nevertheless, in our mannequin, the market can break down if commerce includes sellers which might be topic to steadiness sheet constraints. The chance of market break-down may be self-fulfilling, because it leads traders with out urgent liquidity must promote preemptively in an effort to keep away from the potential for having to promote at decrease costs sooner or later.

Particular person traders might desire promoting preemptively as we speak in the event that they anticipate circumstances to deteriorate sufficiently tomorrow. Combination gross sales as we speak have a direct impact on the value as we speak, however additionally they have an oblique impact on the value tomorrow, via their results on supplier steadiness sheets. If this steadiness sheet impact is sufficiently robust, a person investor’s incentive to promote preemptively may be larger if many different traders additionally promote preemptively. When others are promoting as we speak, an investor would somewhat promote as we speak than wait and threat having to promote tomorrow, by which period sellers could also be over-loaded with stock, leading to a lot decrease costs.

Flight to Security Can Set off a Sprint for Money

Surprisingly, we present that flight to security episodes can exacerbate the sprint for money when markets are fragile. Demand by flight-to-safety traders early on in a stress episode will increase costs each contemporaneously and, by enjoyable supplier steadiness sheets, sooner or later. If the strategic considerations of liquidity traders are sufficiently robust, then extra demand from safety-first traders as we speak can induce liquidity traders to promote as we speak, exactly as a result of the market as we speak has a comparatively larger capability to soak up gross sales. Then, a flight to security really triggers a splash for money, amplifying present market fragility.

How Was March 2020 Completely different from September 2008?

The occasions of March 2020 make a hanging distinction to the nadir of the nice monetary disaster in September 2008, when Treasury markets didn’t undergo from dysfunction and illiquidity. Our mannequin helps to know the variations between these two episodes. First, our mannequin highlights the central function of supplier steadiness sheet constraints that will partly be a results of post-crisis laws. Second, the liquidity wants through the COVID-19 disaster seem to have been a lot bigger—for instance, due to the disruptions from lockdowns globally. Our mannequin due to this fact means that in March 2020, the mixture of unprecedented liquidity wants and significantly extra constrained sellers tilted the Treasury market right into a fragile area the place traders promote strategically, and flight to security precipitates a splash for money.

Classes for the Future

Fragility in our mannequin hinges on the intertemporal concerns of strategic liquidity traders who examine costs as we speak to costs tomorrow. Normally, there’s scope for coverage interventions that improve costs each within the current and sooner or later. Nevertheless, the timing of coverage interventions is vital, and bulletins can have giant results properly earlier than the interventions are executed. We present that an asset buy facility can have a big impact upon announcement by shifting strategic traders from the “run” equilibrium to the “maintain” equilibrium, even when the power doesn’t turn into lively till a future date. Equally, coverage interventions that calm down supplier steadiness sheet constraints may be stabilizing as long as they calm down steadiness sheet constraints sooner or later as properly.

Lastly, our mannequin exhibits that markets the place buying and selling happens in a decentralized, sequential manner and the place sellers play a big function in intermediating flows are inherently fragile. Adjustments to market construction whereby trades are pooled to cut back the function of sellers can due to this fact cut back the fragility of secure asset markets. Duffie (2020) argues that the expansion of the Treasury market since 2008 has enormously outpaced the capability of supplier steadiness sheets to soak up the extra provide and that this pattern is anticipated to proceed. The strategic mechanism in our mannequin is due to this fact more likely to turn into more and more related, suggesting that—absent coverage interventions—episodes comparable to March 2020 might turn into extra frequent.

Photo of Thomas Eisenbach

Thomas M. Eisenbach is a monetary analysis advisor in Cash and Funds Research within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.

Gregory Phelan is an affiliate professor of economics at Williams Faculty, presently working as a senior researcher within the U.S. Treasury’s Workplace of Monetary Analysis. 

How you can cite this publish:
Thomas Eisenbach and Gregory Phelan, “How Can Protected Asset Markets Be Fragile?,” Federal Reserve Financial institution of New York Liberty Avenue Economics, September 8, 2022, https://libertystreeteconomics.newyorkfed.org/2022/09/how-can-safe-asset-markets-be-fragile/.

The views expressed on this publish are these of the writer(s) and don’t essentially replicate the place of the Federal Reserve Financial institution of New York or the Federal Reserve System. Any errors or omissions are the duty of the writer(s).

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