Benchmark tipping in the money and bond markets

The possibility that the stock of outstanding US Treasury securities may shrink significantly raises the question of how the broader US dollar fixed income market might operate in their absence. Market participants have come to rely heavily on US Treasury securities as benchmarks for pricing other securities, as means of hedging and positioning in both duration and volatility, as bases for futures market contracts and as collateral for secured borrowing. One approach to answering this question reaches back almost a century: to examine the workings of the US bond market in the period before the First World War when there was little in the way of government debt. This earlier era, however, lacked many features that are now important to the functioning of financial markets, such as mortgage-backed securities, futures and options. As a result, it may be hard to draw reliable inferences from this earlier experience. This special feature approaches the question by examining the changing roles of Treasury and other obligations in the dollar money market over the last generation for clues as to how their relative roles might evolve in the dollar bond market. This approach considers a time when the modern instruments of finance were in use. The principal finding of this special feature is that private instruments eclipsed government paper as a benchmark in the dollar money market over the last two decades even as government debt grew rapidly. The shift followed a “tipping” process in which market participants found it advantageous to use first one, and then another, instrument in line with the preponderant choice of other market participants. More recently, the bond market has shifted away from its reliance on government securities and might well have continued to do so even had there been no reduction in the stock of outstanding US government paper. On this view, therefore, any sustained reduction in the supply of the US Treasury’s obligations would only accelerate this shift.