The Treasury market in spring 2020 and the response of the Federal Reserve

Summary

Focus

In March 2020, as the Covid-19 crisis intensified, stress emerged in the market for Treasury securities. During the period 9–18 March, the 10-year yield surged sharply by 64 basis points while the stock market kept falling. This is contrary to typical risk-off events which are characterised by a simultaneous drop in equity prices and long-term yields. In response to these developments, on 15 March 2020 the Board of Governors of the Federal Reserve System (the Fed) unveiled a new programme to buy large amounts of Treasuries. Purchases exceeded $1 trillion in Q1 2020. This paper seeks to provide new facts and analysis to improve understanding of the episode.

Contribution

The paper shows that Treasury yields did not spike due to a loss of confidence in Treasury fundamentals. Once default risk, inflation and illiquidity are ruled out as central drivers of the increase in Treasury yields, the natural explanation is a negative demand shock, necessitating a fall in Treasury market prices to bring supply and demand into equilibrium. The paper studies whether Fed purchases were instrumental for reversing the yield spike and then characterises the negative demand shock. It documents unusually large sales of Treasury securities by certain investor groups and investigates the drivers of such selling, providing novel insights and empirical support.

Findings

The yield spike was driven by urgent liquidity needs of mutual funds, foreign official agencies and hedge funds. These needs were unchanged by the Fed's announcement on 15 March 2020 necessitating large actual purchases to reverse the yield spike. The paper finds that Fed Treasury securities purchases were causal in reducing Treasury yields on the basis of: (1) the timing of purchases (which increased on 19 March); (2) evidence against confounding factors; and (3) the timing of yield reversal and Fed purchases in the mortgage-backed securities market. The large impact of yields at the time of purchase contrasts with prior quantitative easing (QE) programmes and suggests a shortage of arbitrage capital.

Abstract

Treasury yields spiked during the initial phase of COVID. The 10-year yield increased by 64 bps from March 9 to 18, 2020, leading the Federal Reserve to purchase $1T of Treasuries in 2020Q1. Fed Treasury purchases were causal for reducing Treasury yields based on (1) the timing of purchases (which increased on March 19), (2) evidence against confounding factors, and (3) the timing of yield reversal and Fed purchases in the MBS market. Treasury-QE worked more via purchases than announcements. The yield spike was driven by liquidity needs of mutual funds, foreign official agencies, and hedge funds that were unaffected by the March 15, 2020 Treasury-QE announcement.

Keywords: Treasury bonds, COVID, Federal Reserve, quantitative easing.

JEL classification: E5, G1.