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Levi Long
Levi Long

Dealer*inventory UPD


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dealer*inventory



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Strains in the Treasury market in March indicated a decline in broker-dealer inventory capacity, which has historically predicted persistent reductions in market liquidity across asset classes, the availability of financing for non-financial firms, and real activity.


The analysis in this note, based on the price and quantity of liquidity in the Treasury market, suggests that dealer inventory capacity declined notably in March while investors' demand for dealer-provided liquidity soared, causing the price of liquidity to rise. Through mid-April, dealer inventory capacity is estimated to have declined somewhat further, while investors' liquidity demand retraced completely its earlier rise.


A tightening of dealer inventory constraints of the magnitude observed in March and April has historically been associated with a notable persistent decline in market liquidity in multiple asset classes (including corporate bonds, equities, and agency mortgage-backed securities), a significant persistent deterioration in corporate financing conditions, and a rise in the unemployment rate.2 In contrast, a rise in investors' demand for dealer-provided liquidity has historically been associated with a transitory increase in illiquidity outside Treasury markets and has had no historical relation with corporate financing conditions or real activity.


Federal Reserve interventions in financial markets in recent months may have importantly affected the evolution of dealers' liquidity supply and investors' demand for dealer-provided liquidity. This note explores the channels through which such interventions might affect liquidity supply and demand. However, the analysis cannot attribute changes in liquidity supply and demand to particular announcements or events, especially in periods when multiple policy announcements occur on the very same day.


MethodologyThis note uses an estimated structural vector autoregression (VAR) model of the price and quantity of market liquidity in the Treasury market. Changes in the price and quantity of liquidity are parsed into shifts in dealers' liquidity supply and investors' demand for dealer-provided liquidity. An inward shift in liquidity supply reflects a tightening in dealer inventory constraints.


Remarks about dealers' liquidity supply and investors' demand for dealer-provided liquidityDealers' liquidity supply curve is upward-sloping, implicitly reflecting convex costs of using their balance sheets to provide liquidity to investors. When investors' liquidity demand curve shifts outward, the price (and quantity) of liquidity increases. In this sense, an outward shift in liquidity demand leads to a higher price of liquidity by "clogging" dealer balance sheets. Thus, dealer inventory constraints are important in determining how the price and quantity of liquidity change when investors' demand for liquidity increases. However, this "clogging" of dealer balance sheets is conceptually different from an inward shift in the liquidity supply curve. An inward shift in the liquidity supply curve reflects a tightening of dealer constraints arising outside of the Treasury market. For example, if dealers experience trading losses, money-market funds become less willing to provide secured funding to dealers, or regulations tighten, dealers' liquidity supply curve in the Treasury market might shift inward.7


Data and liquidity supply and demand measuresFigure 2 shows the time series of noise and dealer gross positions. To aggregate across securities, noise on each day is defined as the absolute average deviation between model-implied and observed market yields, for nominal Treasury coupon securities with remaining maturity of 2 to 10 years. Dealer gross positions are the sum of all primary dealers' gross long and gross short positions in nominal Treasury coupon securities.8 These are the inputs in the model.


Zooming in on the last two years of data (right panel in Figure 2), noise rose significantly in March but declined somewhat in April. In contrast, dealer gross positions increased modestly in March but declined notably in April. The model translates these developments into estimated shifts in liquidity supply and demand curves.


Figure 3 presents information from the model about dealers' liquidity supply and investors' liquidity demand. I define the liquidity supply index as the quantity of liquidity that (according to the model) dealers would provide if the price of liquidity were 1 basis point.9 Similarly, I define the liquidity demand index as the quantity of liquidity that investors would demand if the price of liquidity were 1 basis point. An increase in the liquidity supply index thus captures an outward shift in liquidity supply. Similarly, an increase in the liquidity demand index captures an outward shift in liquidity demand. Table 1 presents information about recent shifts in liquidity supply and demand and compares recent experience with important historical episodes over the past three decades, such as the failure of the Long-Term Capital Management hedge fund or the Lehman collapse.


However, preliminary data for April suggest that the rise in investors' demand for dealer-provided liquidity retraced in late March or April. The estimated decline in investors' demand for dealer-provided liquidity was the largest decline, in percentage terms, since 1990.


Role of Federal Reserve operations related to the Treasury marketFederal Reserve interventions in financial markets in recent months may have importantly affected the evolution over this period in dealers' liquidity supply and investors' demand for dealer-provided liquidity.


Operations in which the Federal Reserve lends to dealers against Treasury or other collateral might increase the availability of financing to dealers and reduce their funding risks.10 Such operations might therefore lead to an outward shift in dealers' liquidity supply curve in the Treasury market.


Operations in which the Federal Reserve lends to foreign central banks against Treasury collateral might allow foreign central banks and investors to obtain dollar funding without selling Treasury securities. Thus, such operations might lead to an inward shift in the demand for dealer-provided liquidity in the Treasury market.11


Treasury purchase operations, except when limited to securities with very short remaining maturity, absorb duration risk and might reduce term premiums. These effects of purchases might bolster dealers' risk-bearing capacity, contributing to an outward shift in dealers' liquidity supply curve.12 Because Treasury purchase operations are typically conducted to concentrate purchases in the cheapest securities within maturity buckets, Treasury purchase operations might also reduce the demand imbalances that give rise to noise, thereby leading to an inward shift in investors' demand for dealer-provided liquidity.


Unfortunately, the empirical model used in this note cannot attribute changes in liquidity supply and demand to particular announcements and events. Such an attribution is challenging for two main reasons. First, the model is not able to provide a high-frequency description of liquidity supply and demand changes during narrow windows around policy announcements or operations, especially in periods when many policy announcements are made in the same day. Second, it is difficult to pin down the expected timing of the effects of Federal Reserve operations on dealers' liquidity supply or investors' liquidity demand in the Treasury market. Would these operations affect liquidity supply only upon the announcement of unexpected operations? What would be the effect of the execution of pre-announced operations? As suggested by Duffie (2010), a number of institutional impediments such as search-and-matching frictions can importantly affect the immediate effect of an unexpected announcement of operations and the evolution of this effect over time.


Understanding liquidity in the Treasury market is also useful because the Treasury market is typically highly liquid and Treasury securities have amongst the highest credit quality. Thus, a shortage of market liquidity in the Treasury market provides an important signal about liquidity in the broader universe of financial markets. Moreover, many of the dealers that provide liquidity in the Treasury market are active across financial markets. We can therefore use the Treasury market to extract a signal about dealers' inventory constraints more broadly.


Historically, declines in liquidity supply in the Treasury market have been associated with contemporaneous and persistent declines in liquidity in a wide range of dealer-intermediated markets (see, for example Goldberg, 2020). One such market is that of corporate debt, for which declines in liquidity supply can lead to reductions in corporate debt issuance. Indeed, corporate debt issuance has historically declined following declines in Treasury market liquidity supply.13 Moreover, Goldberg and Nozawa (forthcoming) show that declines in dealers' liquidity supply in corporate bond markets are associated with higher risk premiums for corporate bonds. 041b061a72


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