OFR Models One Theory on the Cause of March 2020’s Treasury Market Fragility
Published: April 3, 2023
Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury.
Treasury prices typically increase during times of stress. Yet, in March 2020, when financial markets experienced stress from the onset of the COVID-19 pandemic, Treasury prices dropped precipitously. Extraordinary policy interventions by the Federal Reserve were needed to resolve this fragility.
In a recent OFR Staff Report, “Fragility of Safe Asset Markets,” the authors model one reason why this highly unusual behavior occurred. They find that markets for safe assets can be fragile, due to strategic interactions among investors who hold Treasury securities for their liquidity characteristics. The standard flight-to-safety in times of stress can have a destabilizing effect and trigger a dash for cash or even a market run by liquidity investors. This explanation offers valuable insights for policymakers on how to support Treasury market liquidity going forward.
Background: Treasury Markets Functioned as Expected at the Onset of the Pandemic, Then Sharply Reversed Course
Safe assets, such as U.S. Treasuries, play several unique roles in the economy. Safe assets are safe, meaning they are expected to pay their full par value at maturity with near total certainty. Safe assets are also liquid, and investors hold safe assets to sell them when they’re faced with a sudden need for cash. The proper functioning of safe asset markets is critical for financial stability.
During times of stress, demand for safe assets typically increases, pushing up their price. This is often referred to as flight-to-safety. At the onset of the COVID-19 pandemic, the Treasury market reacted in this way, as many expected. From mid-February to early March of 2020, the gradual realization of the severity of the COVID outbreak led to a decline in the price of risky assets and a concurrent increase in the price of safe assets, as reflected by the 10-year Treasury price.
But then, in mid-March, Treasury prices suddenly reversed their increase and declined together with stock prices in an unprecedented reversal of the typical negative correlation of safe and risky assets during times of stress. The U.S. Treasury market experienced high levels of illiquidity and unprecedented sales at a time when, historically, prices have rallied. The authors set out to determine why.
Analysis: Fear of a Market Breakdown Can Be a Self-Fulfilling Prophecy
Investors sell safe assets during times of stress to increase their liquidity. This dash for cash (as it is commonly called) exerts downward pressure on the price of safe assets. If the market is sufficiently deep, a flight-to-safety and a dash for cash are complementary phenomena, with investors who buy the assets for safety absorbing sales from investors who sell the assets for liquidity. On the other hand, the market for safe assets tends to rely heavily on dealers to intermediate trades—and the market can break down if trades involve dealers that are subject to balance sheet constraints. If dealers face costs for intermediating on their balance sheets, then dealers can become bottlenecks during times of stress, causing price volatility to increase in safe asset markets.
The risk of a market breakdown can be self-fulfilling because it leads investors without pressing liquidity needs to sell preemptively, to avoid the possibility of having to sell at lower prices in the future. Individual investors may prefer selling preemptively today if they expect conditions to deteriorate sufficiently tomorrow. Aggregate sales today have a direct effect on the price today, but they also have an indirect effect on the price tomorrow, through their effects on dealer balance sheets. If this balance sheet effect is sufficiently strong, an individual investor’s incentive to sell preemptively can be higher if many other investors also sell preemptively. When others are selling today, an investor would rather sell today than wait and risk having to sell tomorrow—by which time, dealers may be overloaded with inventory, resulting in much lower prices.
Methodology: Modeling Behavior in Times of Tress
To determine what could lead to Treasury market fragility, the authors developed a theoretical model of a safe asset market with three types of market participants: investors valuing safety, investors valuing liquidity, and constrained dealers. The authors then modeled how these three groups behave in times of stress.
Results: The Dash for Cash Can Become a Market Run
The model showed that while safety investors and liquidity investors can interact symbiotically with offsetting trades in times of stress, liquidity investors’ strategic interaction harbored the potential for self-fulfilling fragility. Worried about having to sell at potentially worse prices in the future, liquidity investors may sell preemptively, leading to self-fulfilling market runs that are like traditional bank runs in some respects.
Conclusion: Dealer-focused Markets Are Fragile, but Policymakers Can Help
The authors show that flight-to-safety episodes can exacerbate the dash for cash when markets are fragile. Demand by flight-to-safety investors early on in a stress episode increases prices both contemporaneously and, by relaxing dealer balance sheets, in the future. If the strategic concerns of liquidity investors are sufficiently strong, then additional demand from safety-first investors today can induce liquidity investors to sell today, precisely because the market today has a relatively higher capacity to absorb sales. Then, a flight-to-safety triggers a dash for cash, amplifying existing market fragility.
This explains how safe asset markets can experience price crashes, as in March 2020, and it also shows how policymakers can support Treasury market liquidity going forward. Announcements and timing of policy interventions can have large effects, well before the interventions are executed. The authors show that an asset purchase facility can have a large effect upon announcement by shifting strategic investors from the “run” equilibrium to the “hold” equilibrium, even if the facility does not become active until a future date. Similarly, policy interventions that relax dealer balance sheet constraints can be stabilizing, so long as they relax balance sheet constraints in the future as well.
Finally, the model shows that markets where dealers play a large role in intermediating sequential flows are inherently fragile. Reducing the role of dealers by making changes to market structure, whereby trades are all-to-all, can therefore reduce the fragility of safe asset markets.