COVID-19 Pandemic Caused Sovereign Bond Market Disruptions

Due to the COVID-19 pandemic’s effects on the economy, investors around the world quickly sold securities to get cash. This selling pressure happened on all advanced sovereign bond markets. It made the markets work worse, which led the central bank to take a number of actions. In this post, we talk about the results of a recent paper in which we show that these problems happened more often in the U.S. Treasury market than in other sovereign bond markets. We also explain why investors sold more in the U.S. Treasury market than in other sovereign bond markets.

The COVID-19 pandemic caused trouble in the markets for sovereign bonds.
At the beginning of the COVID-19 pandemic in late February 2020, when lockdown measures were about to be put in place, investors started to want higher-quality, safer assets. In particular, they changed their portfolios to include more sovereign bonds. As a result, people bought more sovereign bonds, which made yields on all sovereign bonds go down. As the crisis got worse in March 2020, however, investors’ need for cash went through the roof. This led to a rush to sell sovereign bonds, which caused their yields to go up.

Along with these changes in yields, the liquidity of sovereign bonds got a lot worse in March 2020. For example, between late February and March 2020, the bid-ask spreads for ten-year sovereign bonds from the U.S., Germany, the U.K., and Japan all went up.

Even though there were selling pressures on all sovereign bonds in March 2020, the biggest effect was on the U.S. Treasury markets. For example, the normalised bid-ask spread worsened more for U.S. Treasuries than for German, U.K., and Japan sovereign bonds (see the chart below), even though the normalised bid-ask spread for U.S. Treasuries is usually lower and more stable than that for German, U.K., and Japan sovereign bonds.

The U.S. Treasury market had a lot more selling pressure than it should have.
During the COVID-19 shock, investors of all kinds sold more U.S. Treasuries than they did in other major sovereign bond markets. This was partly because the U.S. dollar is the most important currency for both investments and funding.

All of the major currencies’ reserves were sold by central banks, but the sales of U.S. dollar assets were much bigger. In fact, it was thought that sales of U.S. dollar reserves made up more than 80% of all sales of reserves. This is much more than the U.S. dollar’s roughly 60% share of foreign exchange reserves.

The sales of U.S. Treasuries by private investors were also bigger than sales of other sovereign bonds. Investor transactions and holdings of sovereign bonds in Japan and Italy suggest that most bond sales in March 2020 were to foreign investors. Domestic nonbank investors, such as asset managers, insurers, and pension funds, seemed to either buy more sovereign bonds or stay about the same (see chart below). In contrast, selling pressures in the U.S. Treasury market were widespread. Both foreign investors and U.S. domestic mutual funds, which hold a large share of marketable Treasury holdings, were large net sellers of U.S. Treasuries in the first quarter of 2020.

At the same time, banks in other countries seemed to play a much bigger role than banks in the United States in absorbing investor sales. Japan and Italy’s data show that banks made a lot of net purchases, which helped make up for the amount of sales made abroad (see the chart above). In the first three months of 2020, on the other hand, U.S. banks sold a small amount of U.S. Treasuries.

More selling pressure on Treasuries was caused by the fact that they had more debt.
There were more net sales of U.S. Treasuries in early 2020 because of differences in the supply of securities and the buying of Treasuries by entities with debt, like relative value hedge funds. From the beginning of 2017 until right before the March 2020 shock, U.S. Treasury securities (except those held in the Federal Reserve’s System Open Market Account) grew by more than $3 trillion, while growth in other countries was either small (the U.K. and France) or negative (Germany and Japan). Heavy Treasury issuance was one of the reasons that leveraged funds bought up a lot of U.S. Treasuries. This made U.S. Treasuries much more likely to be deleveraged quickly during the March shock. From what people on foreign markets told us, leveraged funds’ involvement in sovereign bond markets was not as big before the crisis.

Market Microstructure Differences Were Less Consequential
In our paper, we also look at how different bond market structures may have made strains worse or less severe. We find that these factors, such as market-maker obligations, the amount of liquidity provided by nonbanks, the degree of central vs. bilateral clearing, and the number of electronic vs. voice trades, may have played a small role in how sovereign bond markets worked in early 2020, but they were not major sources of difference.

Takeaways
During the COVID-19 pandemic, investors sold many different kinds of assets. However, the U.S. Treasuries market did not work as well as other sovereign bond markets. We say that the relatively bigger drop in how well the Treasury market worked was caused by strong and widespread selling pressures, which were mostly caused by the dollar’s dominance as an investment and funding currency and by the fact that there were a lot of levered entities in the Treasury market at the beginning of 2020.

There are still questions about how well the Treasury market will handle pressure to sell from a wide range of investors in the future. Since March 2020, the Standing Repo Facility and the FIMA Repo Facility were added by the Federal Reserve. This was a big change in the Treasury market. With these liquidity facilities, eligible counterparties can trade Treasuries for cash at a rate that is set by the government. As a stable source of funding, these new programmes could make it less important to sell during times of low liquidity. This would help the market run more smoothly.

Also, the Treasury market could go through major changes. Changes that have been suggested include expanding central clearing, registering active trading firms that buy and sell securities as dealers with the SEC, keeping a closer eye on trading platforms, and making data reporting better.