The past several months have seen a flurry of activity in the official sector1 regarding US Treasuries, as policymakers and stakeholders attempt to explain the startling dislocations that hit the Treasury market — generally considered to be the world’s deepest, most liquid securities market — in March 2020.
Indeed, it was only through swift, aggressive intervention by the US Federal Reserve (Fed) that said market dislocations did not become even more pronounced. It marked the second time in just a few years that the central bank had to intervene in the Treasury market to restore and encourage orderly operations — the other time being the Fed’s purchase of T-bills in the fall of 2019, which was designed to stabilize the short-term interest-rate market.
Understanding what happened in March 2020
So what led to the Treasury market dislocations and illiquidity back in March 2020? At a high level, the prevailing narrative is that several factors occurred all at once to create a “perfect storm,” including:
- Leveraged market participants who exploited basis trades in cash futures markets were forced to unwind positions due to “stop outs” and garnering repo (repurchase agreement) financing.
- For a number of reasons, many dealers and market makers were sensitive to the growth of their balance sheets during volatile market periods.
- Many non-US central banks and governments sold US Treasuries to meet their expected liquidity and currency exchange-rate policy needs.
- Many liability-driven investors rebalanced their portfolios into equities, reducing demand for longer-duration US Treasuries.
- Government-only money market funds saw substantial inflows, boosting demand for T-bills and placing severe pressure on the front end of the market.
Steps to strengthen and protect the market
The official sector’s robust and largely effective response to the above developments in the midst of the COVID-19 crisis has been well detailed by policymakers and observers alike. And it is clear that Treasury securities remain one of the most important channels for the execution of US monetary policy, essentially requiring the Fed’s attention during periods of market upheaval. Yet it’s equally clear to many market participants that more needs to be done to protect the Treasury market for the longer term.
Case in point: If the global reserve currency’s (i.e., the US dollar’s) sovereign debt market undergoes further periodic bouts of dysfunctionality, particularly at the exact moments when investors may need it most for liquidity and price discovery, then Treasury market behavior will likely only add fuel to broader market volatility.
However, future episodes can be mitigated. The Fed’s standing repo facility, launched in the early days of COVID, was a good start toward fortifying the Treasury market for the years ahead. More rapid expansion of this facility to a wider range of market participants (not just primary securities dealers) will be critical to its long-term efficacy, as will be the permanence of the Foreign and International Monetary Authorities’ (FIMA’s) repo facility.
There is also an evolving consensus on expanding central clearing for both Treasuries and Treasury repos. While operational challenges remain, over time, this would likely enhance the capital efficiency and resilience of the Treasury market.
The argument for Treasury buybacks
One underexplored route in efforts to strengthen the Treasury market is the potential establishment of a Treasury buyback program. The Treasury Department can and, I believe, should execute buybacks either via outright purchases or through so-called “switch” operations.
For the sake of this discussion, these operations could either: 1) buy back existing, less liquid “off-the-run” securities in exchange for balances held at the Treasury General Account (TGA); or 2) allow market participants to receive T-bills or some predetermined “on-the-run” securities. Switch operations like these would give the US Treasury the ability to relieve market pressure and improve market liquidity during periods of heightened volatility. There is also an argument for these operations to become a more “normal” part of the Treasury’s toolbox (and not just for highly volatile periods):
- The Treasury would likely be able to better manage its overall weighted-average maturity profile, while also smoothing out security issuance and cash-flow volatility related to large coupon payments and maturity dates.
- The process could temper the issuance volatility that often results from seasonality and having to maintain a minimum TGA cash balance with the Fed.
In short, a Treasury buyback program would deliver benefits and be consistent with the Treasury Department’s policy of regular and predictable security issuance.
The “wake-up calls” provided by the market turmoil of 2019 and (especially) 2020 have underscored the need for a more proactive approach to ensuring that the US Treasury market remains orderly, functional, and robust for the long run.
1The “official sector” comprises official government institutions such as global central banks, government departments and agencies, and government-controlled institutions other than commercial banks, as well as international institutions such as the World Bank and the International Monetary Fund.