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



#Understanding #Inconvenience #Treasury #Bonds

Editor’s word: Since this publish was first printed, a reference within the second paragraph to main 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 likely one of the most liquid monetary markets on the planet, and Treasury bonds have lengthy been thought of a secure haven for world traders. It’s usually believed that Treasury bonds earn a “comfort yield,” within the sense that traders are keen 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, for the reason that world monetary disaster (GFC), long-maturity U.S. Treasury bonds have traded at a yield constantly above the rate of interest swap price of the identical maturity. The emergence of the “adverse swap unfold” seems to recommend that Treasury bonds are “inconvenient,” at the very least relative to rate of interest swaps. This publish dives into this Treasury “inconvenience” premium and highlights the function of sellers’ stability sheet constraints in explaining it.

Major Sellers’ Treasury Place, Unfavourable Swap Unfold, and Cross-Forex Foundation

As in our latest Staff Report, we start with a placing chart exhibiting a robust correlation between main sellers’ web Treasury place and the swap unfold (see chart under). Pre-GFC, when sellers total had a net-short place in Treasury bonds, the swap unfold was constructive. The signal flip within the swap unfold coincides with main 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’ web place, the extra adverse the swap unfold, or the extra “inconvenient” the Treasury bonds.

Swap Unfold, CIP Deviations, and Major 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 Type FR 2004, Major Authorities Securities Sellers Stories.
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 purple), and first sellers’ web 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 principle distinction between holding a Treasury bond and holding an rate of interest swap is that the Treasury bond stays on the supplier’s stability sheet, however the swap is off-balance-sheet. The tightening of the non-risk-weighted leverage ratio constraint post-GFC makes a big stability sheet pricey for banks, even when the underlying positions have little danger.    

The tight correlation between the swap spreads and the cross-currency foundation (the purple line) post-GFC, additionally proven within the chart above, additional helps the declare that middleman stability 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 mirror the shadow value of the middleman stability sheet constraint (as proven in this article and this article). Specifically, a bigger main supplier Treasury place corresponds to a tighter stability sheet constraint, and subsequently, a extra adverse 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, main sellers’ Treasury place is extremely correlated with the slope of the yield curve: sellers improve their Treasury place when the yield curve is flatter. The explanation for this relationship is that because the Treasury yield curve flattens or inverts—a recurring characteristic of the financial coverage tightening cycle—real-money traders (comparable to mutual funds, and overseas insurers that hedge their greenback forex danger utilizing short-term forwards) scale back their demand for Treasury bonds on account of decrease anticipated returns on the bonds. Because of this, sellers (or levered traders that depend on sellers’ stability sheets) must additional improve their Treasury holdings, which tightens sellers’ stability sheet constraints, resulting in a extra adverse swap unfold (and better revenue for sellers who go lengthy in Treasury bonds hedged with rate of interest swaps).

Time period Spreads and Major Seller Treasury Holdings

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

Placing in a Time period Construction Mannequin

Within the paper, we construct a constant framework that includes constrained sellers, levered traders funded by supplier stability sheets, and return-seeking actual cash traders 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’ stability 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, per the change within the sellers’ place (see chart under).

Mannequin-Implied and Precise Treasury Yields (10-Yr 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. Knowledge 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 traces, and the exemption of Treasury securities from the supplementary leverage ratio calculation. Specifically, throughout a financial coverage tightening cycle, our mannequin means that the yield curve inversion and the Federal Reserve stability 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 would possibly result in fragility within the Treasury market. However, we’ve abstracted two latest developments from our framework which may make the present tightening cycle completely different. First, the massive amount of money piled within the in a single day reverse repo facility may also help take up the Treasury bonds and alleviate the middleman stability sheet constraints. Second, better rate of interest volatility can discourage the build-up of sellers’ stock and the levered traders’ place on account of further value-at-risk-type constraints, which have been abstracted from our framework. General, main sellers’ Treasury stock and varied intermediation spreads must 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 College of Enterprise.

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

Methods 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 mirror 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 creator(s).