In a staff report from the New York Federal Reserve, authors and researchers Darrell Duffie, Michael Fleming, Frank Keane, Claire Nelson, Or Shachar, and Peter Van Tassel show that there is a significant loss in US Treasury market functionality when intensive use of dealer balance sheets is needed to intermediate bond markets, as in March 2020.
Although yield volatility explains most of the variation in Treasury market liquidity over time, when dealer balance sheet utilization reaches sufficiently high levels, liquidity is much worse than predicted by yield volatility alone. This is consistent with the existence of occasionally binding constraints on the intermediation capacity of bond markets.
Among the liquidity metrics analyzed is the specialness-adjusted on-the-run premium. The on-the-run premium, the difference between the market yield of an on-the-run nominal security and a hypothetical off-the-run security with identical cash flows, subsumes repo specialness and liquidity effects. The specialness-adjusted on-the-run premium attempts to isolate the liquidity effects by removing repo specialness.
Specifically, researchers regress the on-the-run premium onto a one-week moving average of repo specialness along with fixed effects for weeks since issuance to capture the auction cycle. For the 10-year note, they include an additional explanatory variable in the regression which is the interaction of repo specialness and an indicator for the first month since the note’s issuance. This interaction term captures the effect of differing levels of specialness for the 10-year note before and after it is re-opened one month after its original issuance.