Class 11: The U.S. Treasury MarketFinancial Markets, Spring 2020, SAIF

Jun Pan

Shanghai Advanced Institute of Finance (SAIF)Shanghai Jiao Tong University

April 22, 2020

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 1 / 27

Outline

The US Treasury (UST) market is unique:▶ The most credit-worthy, essentially free of default risk.▶ Large amount outstanding, highly liquid.▶ Supported by well developed repo and derivatives markets.

UST provides the most important benchmark curve:▶ The reference curve for cost of funds at different borrowing horizons.▶ Price discovery about inflation and macroeconomic fundamentals happens here.▶ Information on US monetary policy also happens here.

UST has also become politically charged:▶ Three rounds of quantitative easing after 2008 and the current infinite QE.▶ Large foreign holdings because of the reserve currency status of US dollar.▶ Financing the large and ever growing deficits of the US government.

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 2 / 27

The Fixed Income Market with UST at its Core

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 3 / 27

Ratios of UST to GDP

US Treasuries to GPD (%)

1960 1970 1980 1990 2000 2010 20200

10

20

30

40

50

60

70

80

US Treasuries MarketableUS Treasury Bills

US Public Debt $23.41T USD.US Treasuries $16.89T USD:

▶ Bills: $2.56T.▶ Notes: $9.99T.▶ Bonds: $2.41T.▶ TIPS: $1.51T.

US Muni’s: $3.85T USD.US GSE’s: $1.83T USD.

中国利率债 55.51 万亿 CNY:▶ 国债 16.79 万亿.▶ 政策银行债 16.09 万亿.▶ 地方政府债 22.63 万亿.

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 4 / 27

Major Holders of UST

Holdings in USD Trillion

1960 1970 1980 1990 2000 2010 20200

2

4

6

8

10

12

14

MMMF+MF+ETFPrivate PensionInsurance CompaniesDepository InstitutionsMonetary AuthorityRest of the World

Holdings as Fraction of Total Marketable Treasuries (%)

1960 1970 1980 1990 2000 2010 20200

10

20

30

40

50

60

70

80

90

100

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 5 / 27

Who Will be Funding the US Deficits?

0

2

4

6

8

10

12

14

16

18Holdings as Fraction of Total Marketable UST (%)

1960 1970 1980 1990 2000 2010 20200

20

40

60

80

100

Non US US Fed US Domestic Mktable UST ($T)

Yearly Difference in Fraction of Holdings (%)

1960 1970 1980 1990 2000 2010 2020-10

-5

0

5

10

0

2

4

6

8

10

12

14

16

Non US US Fed US Domestic UST 10Y Yield (%)

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 6 / 27

Foreign Holdings of UST (USD Trillion)

2002 2004 2006 2008 2010 2012 2014 2016 2018 20200

0.2

0.4

0.6

0.8

1

1.2

1.4Holdings of US Treasuries (USD Trillion)

1.092

1.268ChinaJapan Jan 2020 (USD Billion)

Japan 1211.7China, Mainland 1078.6United Kingdom 372.7Brazil 283.3Ireland 271.4Luxembourg 255.2Switzerland 238.1China, Hong Kong 229.6Cayman Islands 216.1

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 7 / 27

Monthly Net Purchases of US Treasury Securities by China (USD Billion)

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020-50

0

50

US

Tre

asur

ies

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020-50

0

50U

S S

eurit

ies

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020-5

0

5

10

Non

-US

Seu

ritie

s

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 8 / 27

Sharp Drop in Foreign Holdings of UST Amidst Global USD Shortage

Jan Feb Mar Apr May2020

2.84

2.86

2.88

2.9

2.92

2.94

2.96

2.98

3

3.02

0.5

1

1.5

2UST Custody Holdings (Trillion USD)

UST Custody HoldingsUST 10Y Yield (right)

Amidst global dollar shortage,foreign institutions sold USTto raise USD cash.FIMA Repo Facility: FIMAaccount holders can use USTheld at Fed as collateral toborrow USD cash.Announced: March 31.Effective: April 6.

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 9 / 27

FX Reserves Held in Gold vs UST

Jan 2017 Jan 2018 Jan 2019 Jan 20200.9

0.95

1

1.05

1.1

1.15

1.2

1.25

1.3

2.8

2.85

2.9

2.95

3

3.05

3.1

3.15

3.2Global FX Reserves (USD Trillion)

2.844

Held in Gold (left)Held in UST

Jan 2017 Jan 2018 Jan 2019 Jan 2020815

820

825

830

835

840

845

850

855

2.8

2.85

2.9

2.95

3

3.05

3.1

3.15

3.2Global FX Reserves

2.844

Held in Gold (million ounce)Held in UST (USD trillion)

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 10 / 27

Gold

1990 1995 2000 2005 2010 2015 20200

2

4

6

8

10

12

14

16

18

20Since 1990

GoldSPXUST

2002 2004 2006 2008 2010 2012 2014 2016 2018 20200

1

2

3

4

5

6

7Since 2000

GoldSPXUST

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 20200.5

1

1.5

2

2.5

3

3.5

4Since 2010

GoldSPXUST

Jan Feb Mar Apr May2020

0.65

0.7

0.75

0.8

0.85

0.9

0.95

1

1.05

1.1

1.15Since 2020

GoldSPXUST

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 11 / 27

SPX, UST, and Gold

SPX UST GOLDMonthly Returns 1988-2018µ 0.87 0.56 0.42

[4.15] [7.69] [1.91]σ 4.13 1.44 4.34Monthly Returns 2000-2018µ 0.49 0.44 0.82

[1.78] [5.07] [2.72]σ 4.28 1.37 4.68Monthly Returns 2010-2018µ 0.93 0.34 0.42

[2.70] [3.32] [1.02]σ 3.85 1.13 4.52

Corr (%) SPX UST GOLDMonthly Returns 1988-2018

SPX 100UST -8 100GOLD -6 12 100

Monthly Returns 2000-2018SPX 100UST -36 100GOLD 0 24 100

Monthly Returns 2010-2018SPX 100UST -51 100GOLD 2 33 100

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 12 / 27

Monetary Policy and the Yield Curve

The Fed controls the short-end of the yield curve:▶ FOMC meets every six weeks to set the Fed funds target rate.▶ The Fed funds market: depository institutions lend reserve balances to one

another overnight.▶ The Fed uses open market operations to adjust the supply of reserve balances

so as to keep the fed funds rate around the target established by the FOMC.Fed traditionally does not control the long-end of the yield curve, but

▶ Since late 2008, the Fed did three rounds of QE.▶ Since March 2020, the Fed commits to infinite QE.

Absent of the Fed, the fundamental drivers of the long-term interest rates:▶ Inflation expectations.▶ Long-term economic growth.

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 13 / 27

Fed Funds Target Rate, Yield Curve, and Business Cycle

1990 1995 2000 2005 2010 2015 20200

1

2

3

4

5

6

7

8

9

10

Yie

ld (

%)

3-month Treasury 2-year Treasury 10-year Treasury 30-year Treasury Fed Fund Target

Jan Feb Mar Apr2020

0

0.5

1

1.5

2

2.5

Yie

ld (

%)

3-month Treasury 2-year Treasury 10-year Treasury 30-year Treasury Fed Fund Target

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 14 / 27

Fed Funds Target Rate, Macroeconomic Fundamentals, and Yield Curve

Monetary policy decision is informed bymacroeconomic fundamentals and markets.The Taylor (1993) rule is an example:

r = 2% + π + 0.5y + 0.5 (π − 2)

▶ π: rate of inflation.▶ y: deviation of real GDP from a target.

Markets anticipate future Fed actions:▶ The shape of the yield curve (e.g., slope).▶ Federal funds futures and options.

Uncertainties in the target rate affect themarkets. Fed: more transparency and bettercommunications.

Fed’s dual mandate:Price stability.Maximum employment.

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 15 / 27

Macroeconomic Indicators: GDP, Inflation, and EmploymentGDP, Inflation, and Unemployment (1958-2019)

Martin Burns Volcker Greenspan Bernanke

Yellen

Powell

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020-10

-5

0

5

10

15

20

Rat

es (

%)

Real GDP (avg = 3.12%) Core Inflation (avg = 3.67%) Unemployment (avg = 6%)

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 16 / 27

US GDP Forecast

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 17 / 27

CN GDP Forecast

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 18 / 27

CN Q1 2020

2002 2004 2006 2008 2010 2012 2014 2016 2018 2020-10

-5

0

5

10

15China, YoY Real GDP Growth (%)

-6.8%-6%

ActualForecast

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 19 / 27

CN Q1 2020

2002 2004 2006 2008 2010 2012 2014 2016 2018 2020-10

-5

0

5

10

15China, YoY Real GDP Growth (%)

-6.8%-6%

ActualForecast

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 20 / 27

Quantitative Easing and Operation Twist, 2008-2014

When the short-term interest rates reach to zero, how to bring down longer-terminterest rates?

▶ QE1: buy Treasury securities, agency debt, and MBS.▶ QE2: buy Treasury securities.▶ QE3: buy Treasury securities and MBS.▶ Operation Twist: buy longer-term, sell shorter-term Treasury securities.

In buying Treasury securities, the ultimate goal was to precipitate a broad reductionin the cost of credit (e.g., rates on mortgage and corporate bonds).Our purchases of hundreds of billions of dollars of securities were probably the mostimportant and definitely the most controversial tool we would employ.

– Ben Bernanke in The Courage to Act.

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 21 / 27

Three Rounds of QE, 2008-2014

Total Reserve Bank Credit: $4.45T:Securities Held Outright: $4.22T.

▶ UST: $2.46T.▶ Agency: $39.7B.▶ MBS: $1.72T.

Repo: 0.Loans: $206M.Maiden Lane: $1.7B.Central Bank Swaps: 0.

As of Oct 29, 2014.

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 22 / 27

2020 Infinite QE

Securities Held Outright (USD Trillion)

4.8T

3.34T

326B

2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 20220

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

Treasury BillsTreasury Notes/BondsAgencyMBS

Fed announcements:▶ March 15: $700B QE.▶ March 23: Infinite QE.

Total Fed Credit: $5.77T:▶ Securities Held Outright: $4.80T.

⋆ UST: $3.34T.⋆ MBS: $1.46T.

▶ Repo: $263B.▶ Loans: $129B.

⋆ PDCF: $33B.⋆ MMMFLF: $53B.

▶ Central Bank Swaps: $348.5B.As of Apr 1, 2020.

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 23 / 27

Fed Balance Sheet, April 15

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 24 / 27

QE and Treasury Yield Curve

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 25 / 27

UST, USD, and the Fed

2002 2004 2006 2008 2010 2012 2014 2016 2018 20200

1

2

3

4

5

6

7

Yie

ld (

%)

0

0.5

1

1.5

2

2.5

3

3.5

US

D T

rillio

n

10Y Treasury Yield (left axis)Fed Treasury Position (right axis)

2002 2004 2006 2008 2010 2012 2014 2016 2018 20200

1

2

3

4

5

6

7

Yie

ld (

%)

10Y Treasury Yield (%)Fed Funds Target (%)

2002 2004 2006 2008 2010 2012 2014 2016 2018 202070

80

90

100

110

120

130

US

Dol

lar

Inde

x

0

0.5

1

1.5

2

2.5

3

3.5

US

D T

rillio

n

US Dollar Index (left axis)Fed Treasury Position (right axis)

2002 2004 2006 2008 2010 2012 2014 2016 2018 202070

80

90

100

110

120

130

US

Dol

lar

Inde

x

0

1

2

3

4

5

6

7

Fed

Fun

ds T

arge

t (%

)

US Dollar Index (left axis)Fed Funds Target (right axis)

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 26 / 27

Main Takeaways

Financial Markets, Spring 2020, SAIF Class 11: The U.S. Treasury Market Jun Pan 27 / 27