Granular Treasury Demand with Arbitrageurs

Abstract

We collect a novel dataset encompassing the vast majority of the portfolio holders of the U.S. Treasury market and estimate granular demand functions for the Federal Reserve and preferred habitat investors such as commercial banks, mutual funds, and foreign investors. We find that the Fed’s long-term Treasury holdings not only significantly respond to macroeconomic dynamics, but also increase with long-term yields and decrease with short-term yields. Using these demand estimates, we quantify a dynamic equilibrium model of the Treasury market where risk-averse strategic arbitrageurs interact with preferred habitat investors and the Federal Reserve across different maturities. We find that (1) the Treasury market is elastic because of low estimated arbitrageur risk aversion that significantly weakens demand impact; (2) term premium positively responds to monetary policy tightening due to high cross-elasticities, explaining the heightened sensitivity of long-term rates; (3) QE has a weak effect unless the Fed credibly commits to a persistent expansion of its balance sheet.

Presented by Lukas Schmid.