Treasury Market Stress, Lessons from 1958 and Today
Published: June 9, 2022
The U.S. Treasury market is one of the safest and most liquid markets in the world. While disruption in the U.S. Treasury market is uncommon, when it does occur, the sources of disturbance can stem from similar vulnerabilities. Most notably, in March 2020, the Treasury market experienced extreme stress that, while unique and unprecedented in its scale, shares common features with a similar stress episode in 1958. In a brief published today, OFR’s researchers R. Jay Kahn and Vy Nguyen identified five vulnerabilities that were present in 1958 and 2020 to help inform policymakers about the sources of shocks to the Treasury market.
Vulnerability 1: Treasury market intermediation depends on a small pool of dealers who may become constrained during times of crises
Only a handful of primary dealers intermediated a large amount of outstanding Treasury debt in 1958 and March 2020. During these stress episodes, the ability of these dealers to make markets was constrained, leading to evaporating liquidity and a rapid deterioration of market functioning.
Vulnerability 2: Reliance on market-based financing can further exacerbate stress
The Treasury market in both 1958 and 2020 relies on nonbank actors to provide market liquidity. While market-based financing helps maintain funding liquidity in the Treasury market, this reliance can serve as a means of transmitting stress to the Treasury market as investors withdraw liquidity during episodes of high market volatility.
Vulnerability 3: Low margins can amplify selling pressures
Low margin requirements were argued to have played a key role in exacerbating downward price pressures during the 1958 crisis. During this episode, high market volatility led to substantial increases in margins, forcing leveraged investors to sell Treasury securities. Today, while the Federal Reserve Bank of New York reports that margins on tri-party repo remain fairly flat at 2%, margins in other market segments like uncleared bilateral repo may have been significantly lower in the lead-up to March 2020.
Vulnerability 4: Expansion of carry trades may lead to sudden pullbacks in financing
A focal source of stress in the 1958 episode was the use of carry trades (purchases of long-term securities using short-term funds) that enabled a sizeable buildup of positions with low or non-existent margins. Like the cash-futures basis trade today, these trades are vulnerable to increases in margin and sudden pullbacks in financing from the repo market, which can lead to fire-sales in times of stress.
Vulnerability 5: There remains a lack of market transparency
Regulators in 1958 found that they had little data on many aspects of the Treasury market. While much more data is available today to regulators and market participants, key gaps remain, particularly for data on holdings of government securities and the financing of these holdings through the uncleared bilateral repo market.
Although the Treasury market stress in 1958 and 2020 differed in their magnitude and scope, collectively, they have highlighted various underlying structural problems in the Treasury markets. Understanding the source of these problems, and the extent to which its proposed reforms have been successful is crucial to strengthening Treasury market resilience in the future.