The standard “flight to safety” in times of financial stress can have a destabilizing effect, including a “dash for cash” or a market run by liquidity investors – which may have been the dynamics for Treasury market fragility three years ago, according to a blog post published Monday by the Treasury’s financial research arm.
According to the blog post by the Treasury’s Office of Financial Research (OFR), markets for safe assets can be fragile due to strategic interactions among investors holding Treasury securities for their liquidity characteristics.
“Treasury prices typically increase during times of stress,” the OFR wrote in the post titled “OFR Models One Theory on the Cause of March 2020’s Treasury Market Fragility.” The blog post continues that “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.”
According to the blog post, dealer-focused markets are fragile, but policymakers can help. “Announcements and timing of policy interventions can have large effects, well before the interventions are executed,” the blog asserts. Additionally, the post points to an asset purchase facility as a tool that 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,” the post states.
The post notes 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.”
OFR Models One Theory on the Cause of March 2020’s Treasury Market Fragility