Class 14: The U.S.

Treasury Market and Its Monetary Policy

Financial Markets, Fall 2020, SAIF

Jun Pan

Shanghai Advanced Institute of Finance (SAIF)

Shanghai Jiao Tong University

December 14, 2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy 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, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 2 / 27
The Fixed Income Market with UST at its Core

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 3 / 27
Ratios of UST to GDP

US Treasuries to GPD (%) US Public Debt $23.41T USD.

80
US Treasuries Marketable US Treasuries $16.89T USD:
US Treasury Bills
70
▶ Bills: $2.56T.

▶ Notes: $9.99T.
60
▶ Bonds: $2.41T.
50
▶ TIPS: $1.51T.

40 US Muni’s: $3.85T USD.

30 US GSE’s: $1.83T USD.
20
中国利率债 55.51 万亿 CNY:
10 ▶ 国债 16.79 万亿.

▶ 政策银行债 16.09 万亿.

0
1960 1970 1980 1990 2000 2010 2020 ▶ 地方政府债 22.63 万亿.

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 4 / 27
Major Holders of UST

Holdings in USD Trillion Holdings as Fraction of Total Marketable Treasuries (%)

14 100
MMMF+MF+ETF
Private Pension 90
12 Insurance Companies
Depository Institutions 80
Monetary Authority
10 Rest of the World 70

60
8
50
6
40

4 30

20
2
10

0 0
1960 1970 1980 1990 2000 2010 2020 1960 1970 1980 1990 2000 2010 2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 5 / 27
Who Will be Funding the US Deficits?

Non US US Fed US Domestic Mktable UST ($T) Non US US Fed US Domestic UST 10Y Yield (%)

Holdings as Fraction of Total Marketable UST (%) Yearly Difference in Fraction of Holdings (%)
100 18 10 16

16 14
80 14
5 12
12
10
60
10
0 8
8
40
6
6
-5 4
20 4

2 2

0 0 -10 0
1960 1970 1980 1990 2000 2010 2020 1960 1970 1980 1990 2000 2010 2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 6 / 27
Foreign Holdings of UST (USD Trillion)
Holdings of US Treasuries (USD Trillion)
1.4
China 1.268
Japan
1.2 Jan 2020 (USD Billion)
1.092 Japan 1211.7
1
China, Mainland 1078.6
0.8
United Kingdom 372.7
Brazil 283.3
0.6 Ireland 271.4
Luxembourg 255.2
0.4 Switzerland 238.1
China, Hong Kong 229.6
0.2 Cayman Islands 216.1

0
2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 7 / 27
Monthly Net Purchases of US Treasury Securities by China (USD Billion)
50

US Treasuries
0

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

50
US Seurities

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

10
Non-US Seurities

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

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 8 / 27
Sharp Drop in Foreign Holdings of UST Amidst Global USD Shortage
UST Custody Holdings (Trillion USD)
3.02 2

3
Amidst global dollar shortage,
2.98 foreign institutions sold UST
2.96 1.5
to raise USD cash.
2.94
FIMA Repo Facility: FIMA
account holders can use UST
2.92
held at Fed as collateral to
2.9 1 borrow USD cash.
2.88 Announced: March 31.
2.86 UST Custody Holdings
Effective: April 6.
UST 10Y Yield (right)
2.84 0.5
Jan Feb Mar Apr May
2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 9 / 27
FX Reserves Held in Gold vs UST

Global FX Reserves (USD Trillion) Global FX Reserves

1.3 3.2 3.2
855
Held in Gold (left) Held in Gold (million ounce)
Held in UST Held in UST (USD trillion)
1.25 3.15 3.15
850

1.2 3.1 845 3.1

1.15 3.05 840 3.05

1.1 3 835 3

1.05 2.95 830 2.95

1 2.9 825 2.9

0.95 2.844 2.85 820 2.844 2.85

0.9 2.8 815 2.8

Jan 2017 Jan 2018 Jan 2019 Jan 2020 Jan 2017 Jan 2018 Jan 2019 Jan 2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 10 / 27
Gold
Since 1990 Since 2000
20 7
Gold Gold
18 SPX SPX
UST 6 UST
16

14 5

12
4
10
3
8

6 2

4
1
2

0 0
1990 1995 2000 2005 2010 2015 2020 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Since 2010 Since 2020

4 1.15
Gold Gold
SPX 1.1 SPX
3.5 UST UST
1.05

3 1

0.95
2.5
0.9
2
0.85

1.5 0.8

0.75
1
0.7

0.5 0.65
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Jan Feb Mar Apr May
2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 11 / 27
SPX, UST, and Gold

SPX UST GOLD Corr (%) SPX UST GOLD

Monthly Returns 1988-2018 Monthly Returns 1988-2018
µ 0.87 0.56 0.42 SPX 100
[4.15] [7.69] [1.91] UST -8 100
σ 4.13 1.44 4.34 GOLD -6 12 100
Monthly Returns 2000-2018 Monthly Returns 2000-2018
µ 0.49 0.44 0.82 SPX 100
[1.78] [5.07] [2.72] UST -36 100
σ 4.28 1.37 4.68 GOLD 0 24 100
Monthly Returns 2010-2018 Monthly Returns 2010-2018
µ 0.93 0.34 0.42 SPX 100
[2.70] [3.32] [1.02] UST -51 100
σ 3.85 1.13 4.52 GOLD 2 33 100

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy 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, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 13 / 27
Fed Funds Target Rate, Yield Curve, and Business Cycle

10 2.5
3-month Treasury
9 2-year Treasury
10-year Treasury
8 30-year Treasury 2
Fed Fund Target
7

6 1.5
Yield (%)

Yield (%)
5

4 1

3
3-month Treasury
2 0.5 2-year Treasury
10-year Treasury
1 30-year Treasury
Fed Fund Target
0 0
1990 1995 2000 2005 2010 2015 2020 Jan Feb Mar Apr
2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 14 / 27
Fed Funds Target Rate, Macroeconomic Fundamentals, and Yield Curve

Monetary policy decision is informed by Fed’s dual mandate:

macroeconomic fundamentals and markets.
Price stability.
The Taylor (1993) rule is an example:
Maximum employment.
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 the

markets. Fed: more transparency and better
communications.
Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 15 / 27
Macroeconomic Indicators: GDP, Inflation, and Employment
GDP, Inflation, and Unemployment (1958-2019)
20
Real GDP (avg = 3.12%)
Core Inflation (avg = 3.67%)
15 Unemployment (avg = 6%)

10
Rates (%)

-5 Yellen
Martin Burns Volcker Greenspan Bernanke
Powell
-10
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
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US GDP Forecast

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 17 / 27
CN GDP Forecast

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 18 / 27
CN Q1 2020

China, YoY Real GDP Growth (%)

15
Actual
Forecast

10

-5
-6%
-6.8%

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

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 19 / 27
CN Q1 2020

China, YoY Real GDP Growth (%)

15
Actual
Forecast

10

-5
-6%
-6.8%

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

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy 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-term
interest 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 reduction
in 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 most
important and definitely the most controversial tool we would employ.
– Ben Bernanke in The Courage to Act.

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy 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, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 22 / 27
2020 Infinite QE

Securities Held Outright (USD Trillion)

5
Treasury Bills
4.8T
Fed announcements:
4.5 Treasury Notes/Bonds
▶ March 15: $700B QE.
Agency
4 MBS ▶ March 23: Infinite QE.

3.5
3.34T
Total Fed Credit: $5.77T:
3 ▶ Securities Held Outright: $4.80T.

⋆ UST: $3.34T.
2.5
⋆ MBS: $1.46T.
2 ▶ Repo: $263B.

1.5 ▶ Loans: $129B.

⋆ PDCF: $33B.
1
⋆ MMMFLF: $53B.
0.5 ▶ Central Bank Swaps: $348.5B.
326B
0
2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 As of Apr 1, 2020.

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 23 / 27
Fed Balance Sheet, April 15

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 24 / 27
QE and Treasury Yield Curve

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UST, USD, and the Fed
7 3.5 7
10Y Treasury Yield (left axis) 10Y Treasury Yield (%)
Fed Treasury Position (right axis) Fed Funds Target (%)
6 3 6

5 2.5 5

USD Trillion
Yield (%)

Yield (%)
4 2 4

3 1.5 3

2 1 2

1 0.5 1

0 0 0
2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

130 3.5 130 7

US Dollar Index (left axis) US Dollar Index (left axis)
Fed Treasury Position (right axis) Fed Funds Target (right axis)
3 6
120 120

2.5 5

Fed Funds Target (%)

110 110
US Dollar Index

US Dollar Index
USD Trillion
2 4
100 100
1.5 3

90 90
1 2

80 80
0.5 1

70 0 70 0
2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 26 / 27
Main Takeaways

Financial Markets, Fall 2020, SAIF Class 14: The U.S. Treasury Market and Its Monetary Policy Jun Pan 27 / 27