Treasuries and Repo in the Time of COVID-19

Treasuries and Repo in the Time of COVID-19

INSIGHTi
Treasuries and Repo in the Time of COVID-19
July 20, 2020
Background: Three Roles for Treasuries
The U.S. Treasury issues debt securities—known as Treasuries—that play three critical roles in the
economy: funding the government, supplying safe assets, and anchoring liquidity flows in financial
markets. This Insight examines how the coronavirus pandemic has affected al three roles.
Treasuries primarily serve as a means of government finance. The U.S. Treasury sel s securities to obtain
cash to fund government operations when revenues fal short of outlays. The Treasury issues bil s,
maturing within a year, to respond to short-term financing needs. Treasury notes, with maturities up to 10
years, and bonds, with longer maturities, help the government hedge against the risk of rising interest
rates. Most Treasuries first sel in scheduled auctions and then trade in secondary markets.
Investors hand over cash to purchase Treasuries to obtain assets essential y free of default risk that serve
as a store of value as wel as a safe haven against severe market or other unforeseen risks. Interest rate
changes affect the price of Treasuries. Longer-term Treasuries general y carry higher yields to induce
investors to lock up funds for longer times. The yield curve—a plot of Treasuries’ yields ordered by their
maturities—therefore usual y slopes upwards. A downward sloping, or inverted yield curve can signal an
impending economic slowdown.
Treasuries anchor liquidity flows in financial markets largely through repurchase agreements, or repos. A
repo provides a common means of secured lending, often within the nexus of financing arrangements
involving nonbank financial institutions sometimes cal ed the shadow banking system. Most repo trades
use Treasury securities for collateral, intertwining repos and markets for Treasuries. Repos al ow asset
holders to obtain extra revenues on otherwise idle assets. Most U.S. repo lending is overnight, although
some repos continue on a rolling or open basis.
For instance, a hedge fund may sel $100 mil ion in Treasuries to a bank for a day in return for $98
mil ion in cash to fund its operations. The next morning, the hedge fund repurchases the Treasuries,
returning the cash and an interest charge to the bank. That $2 mil ion difference—the haircut—helps
protect the bank from credit and transactions risks. Haircuts for other types of assets are general y higher.
Asset holders and borrowers might also transact a repo through a clearing bank, cal ed a triparty repo.
Hedge funds use repos for leverage by taking short positions on Treasuries—that is, lending borrowed
Treasuries.
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Dramatic Moves in Financial Markets in March 2020
Financial markets reacted sharply once the World Health Organization declared Coronavirus Disease
2019 (COVID-19) a global pandemic on March 11, 2020. In the following week, some market indices had
multiple historic fal s in value, a market adjustment far more sudden than the onset of the financial crisis
of 2007-2009. In Treasuries markets during March 2020, yields on Treasury securities of al maturities
fel (Figure 1), some reaching historic lows. The 10-year bond yield dropped below 1% for the first time
and the 30-year bond had a yield of 1.27%—the one-month T-bil yield a month earlier.
Figure 1. Treasury Yield Curve for March 2 and April 1, 2020

Source: CRS calculations based on U.S. Treasury data on constant maturity rates. Rates in percentage points.
Sudden inflows into money market funds holding government securities and withdrawals from other
money market funds mirrored the rush into Treasuries (Figure 2).
Figure 2. Weekly Changes in Money Market Fund Assets
(Government-Only vs. Prime Funds: Wednesday Levels in $Bil ions)

Source: Investment Company Institute (ICI) data via Wrightson ICAP. Government securities include “Treasury debt,
Treasury repurchase agreements, government agency debt, government agency repurchase agreements, and ‘other’
government securities, or other securities, which contain al remaining non-government securities.”

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What Caused Those Market Movements?
Within the general uncertainty of the COVID-19 pandemic, two factors helped drive these movements.
First, many firms faced severe revenue drop-offs, sparking demand for cash and credit while depressing
risky assets’ prices and raising safe assets’ prices, especial y Treasuries. Post-2007-2009 financial crisis
bank leverage limits were eased to bolster the supply of credit. Surging demand for cash also drove
unusual patterns in Treasury prices, which vary inversely with yields. Asset prices that tended to trend
together, such as Treasuries and stock indices, diverged. Even 10-year Treasury yields and mortgage rates,
which usual y move in tandem, diverged, indicating extraordinary financial stresses. Massive Federal
Reserve support and COVID-19 response efforts funded by Congress helped ease divergences in late
April 2020.
Second, repo lending supports the leveraging strategies of hedge funds and similar entities. One analysis
noted “any sustained disruption in this market, with daily turnover in the US market of about $1 tril ion,
could quickly ripple through the financial system.” COVID-19 stresses prompted deleveraging—a
pullback in the borrowing of safer assets and curtailed demand for risky assets. A hedge fund using a
leveraged funding strategy could exchange Treasuries with a bank to borrow cash. The hedge fund would
then be short on Treasuries—holding a negative position in them—and long on assets purchased with
borrowed cash. Financial theory suggests investors facing higher market volatility reduce short positions
in Treasuries and sel some risky assets. As other firms do likewise, prices of riskier assets fal , further
straining leveraged positions. Avoiding such fire-sale dynamics appeared to spur some Federal Reserve
responses to enhance market liquidity. The shadow banking sector faced more pressure than the formal
banking sector, which bolstered capital reserves following the 2007-2009 financial crisis.
Historic Increase in Treasury Supply Ahead
Congress enacted fiscal responses to the pandemic, including the CARES Act (P.L. 116-136),
scored as costing about $1.7 tril ion, mostly for FY2020 and FY2021. Funding those outlays
implies an unprecedented increase in the issuance of Treasuries. Lowered yields shown in Figure
1 reflect strong demand for Treasuries. Market pricing indicates low interest rates wil persist,
lessening debt service costs. Nevertheless, fiscal chal enges loom. Slower economic activity
reduces federal revenues and expanding public debt underlines preexisting concerns about the
federal fiscal trajectory. Other long-term fiscal chal enges, such as the Baby Boomer retirement
and climate change, remain. Many economists, however, regard responding to COVID-19 as
more important than restraining federal debt at present.

Author Information

D. Andrew Austin
Rena S. Miller
Analyst in Economic Policy
Specialist in Financial Economics

Disclaimer

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