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Understanding the “Inconvenience” of U.S. Treasury Bonds

Editor’s word: Since this publish was first printed, a reference within the second paragraph to major sellers switching positions was corrected to learn “a net-short to a net-long place.” February 6, 10:45 a.m.

The U.S. Treasury market is without doubt one of the most liquid monetary markets on the planet, and Treasury bonds have lengthy been thought-about a secure haven for international buyers. It’s typically believed that Treasury bonds earn a “comfort yield,” within the sense that buyers are prepared to just accept a decrease yield on them in comparison with different investments with the identical money flows owing to Treasury bonds’ security and liquidity. Nonetheless, because the international monetary disaster (GFC), long-maturity U.S. Treasury bonds have traded at a yield constantly above the rate of interest swap fee of the identical maturity. The emergence of the “unfavorable swap unfold” seems to counsel that Treasury bonds are “inconvenient,” no less than relative to rate of interest swaps. This publish dives into this Treasury “inconvenience” premium and highlights the position of sellers’ steadiness sheet constraints in explaining it.

Main Sellers’ Treasury Place, Damaging Swap Unfold, and Cross-Forex Foundation

As in our current Workers Report, we start with a placing chart exhibiting a robust correlation between major sellers’ internet Treasury place and the swap unfold (see chart beneath). Pre-GFC, when sellers general had a net-short place in Treasury bonds, the swap unfold was constructive. The signal flip within the swap unfold coincides with major sellers switching from holding a net-short to a net-long place in Treasury bonds. With this shift in sellers’ positioning, sellers continued to earn a constructive unfold on their Treasury positions hedged utilizing rate of interest swaps. As well as, post-GFC, the bigger the sellers’ internet place, the extra unfavorable the swap unfold, or the extra “inconvenient” the Treasury bonds.

Swap Unfold, CIP Deviations, and Main Sellers’ Web Holdings of Treasury Bonds Are Extremely Correlated

Liberty Street Economics trend chart showing the tight correlation between swap spreads and the cross-currency basis post-GFC.
Sources: Bloomberg L.P.; Federal Reserve Kind FR 2004, Main Authorities Securities Sellers Studies.
Notes: The chart plots the unfold between the thirty-year LIBOR-linked rate of interest swap and the U.S. Treasury yield (in blue), the five-year U.S. greenback–EUR cross-currency foundation (in pink), and first sellers’ internet holdings of coupon Treasury bonds (in gold). The quote on the cross-currency foundation swap successfully measures the direct greenback rate of interest minus the artificial greenback curiosity by swapping euro rate of interest into {dollars} (Du, Tepper, and Verdelhan 2018b).

For sellers, the primary distinction between holding a Treasury bond and holding an rate of interest swap is that the Treasury bond stays on the seller’s steadiness sheet, however the swap is off-balance-sheet. The tightening of the non-risk-weighted leverage ratio constraint post-GFC makes a big steadiness sheet pricey for banks, even when the underlying positions have little threat.    

The tight correlation between the swap spreads and the cross-currency foundation (the pink line) post-GFC, additionally proven within the chart above, additional helps the declare that middleman steadiness sheet capability is a key driver of the Treasury swap unfold. The cross-currency foundation measures deviations from the lined curiosity parity (CIP) situation, a textbook no-arbitrage situation. The CIP deviations replicate the shadow price of the middleman steadiness sheet constraint (as proven in this text and this text). Particularly, a bigger major seller Treasury place corresponds to a tighter steadiness sheet constraint, and subsequently, a extra unfavorable swap unfold and cross-currency foundation.

The Position of the Yield Curve Slope

What drives the first sellers’ Treasury place post-GFC when sellers have a protracted place in Treasury bonds? As proven within the subsequent chart, major sellers’ Treasury place is very correlated with the slope of the yield curve: sellers improve their Treasury place when the yield curve is flatter. The rationale for this relationship is that because the Treasury yield curve flattens or inverts—a recurring function of the financial coverage tightening cycle—real-money buyers (reminiscent of mutual funds, and international insurers that hedge their greenback foreign money threat utilizing short-term forwards) scale back their demand for Treasury bonds as a consequence of decrease anticipated returns on the bonds. Because of this, sellers (or levered buyers that depend on sellers’ steadiness sheets) need to additional improve their Treasury holdings, which tightens sellers’ steadiness sheet constraints, resulting in a extra unfavorable swap unfold (and better revenue for sellers who go lengthy in Treasury bonds hedged with rate of interest swaps).

Time period Spreads and Main Seller Treasury Holdings

Liberty Street Economics trend chart showing Treasury term spreads and primary dealers’ Treasury position.
Sources: Bloomberg L.P.; Federal Reserve Kind FR 2004, Main Authorities Securities Sellers Studies.
Notes: The chart plots the yield unfold between the ten-year Treasury bond and the three-month Treasury invoice (in blue), and first sellers’ internet holdings of Treasury bonds (in pink).

Placing in a Time period Construction Mannequin

Within the paper, we construct a constant framework that includes constrained sellers, levered buyers funded by seller steadiness sheets, and return-seeking actual cash buyers to elucidate these new details. Whether or not the sellers are net-long or net-short in Treasury bonds issues considerably for yields. Utilizing CIP deviations because the proxy for sellers’ steadiness sheet prices, our time period construction mannequin reveals that the Treasury yield curve switched from the dealer-net-short curve to the dealer-net-long curve, in step with the change within the sellers’ place (see chart beneath).

Mannequin-Implied and Precise Treasury Yields (10-12 months Maturity)

Liberty Street Economics trend chart showing the Federal Reserve Bank of New York’s model-implied Treasury yields and actual Treasury yields from 2003-2021.
Sources: Bloomberg L.P.; authors’ calculation.
Notes: The chart reveals the model-implied net-long and net-short curves for Treasury securities, along with the precise Treasury yields. Information are from 2003-21. All yields are par yields.

Implications for Coverage

Lastly, we use our framework to debate the implications of a number of financial and regulatory insurance policies for the Treasury market, together with quantitative easing and tightening, central financial institution swap strains, and the exemption of Treasury securities from the supplementary leverage ratio calculation. Particularly, throughout a financial coverage tightening cycle, our mannequin means that the yield curve inversion and the Federal Reserve steadiness sheet runoff will seemingly create vital stress for monetary intermediaries to soak up Treasury bonds. Because of this, the anticipated build-up within the middleman positions may result in fragility within the Treasury market. Alternatively, we’ve got abstracted two current developments from our framework which may make the present tightening cycle totally different. First, the massive amount of money piled within the in a single day reverse repo facility may also help soak up the Treasury bonds and alleviate the middleman steadiness sheet constraints. Second, better rate of interest volatility can discourage the build-up of sellers’ stock and the levered buyers’ place as a consequence of extra value-at-risk-type constraints, which have been abstracted from our framework. Total, major sellers’ Treasury stock and numerous intermediation spreads needs to be intently monitored by policymakers and market individuals.

Photo: portrait of Wenxin Du

Wenxin Du is a monetary analysis advisor in Capital Markets Research within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.

Benjamin Hébert is an affiliate professor of finance on the Stanford College Graduate Faculty of Enterprise.

Wenhao Li is an assistant professor of finance and enterprise economics on the College of Southern California Marshall Faculty of Enterprise.

The way to cite this publish:
Wenxin Du, Benjamin Hébert, and Wenhao Li, “Understanding the “Inconvenience” of U.S. Treasury Bonds,” Federal Reserve Financial institution of New York Liberty Road Economics, February 6, 2023,

The views expressed on this publish are these of the creator(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 accountability of the creator(s).



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